There were some well-publicised investment recommendations from banks in May and June to ‘buy Spain and Italy’ while avoiding Germany. The logic behind this view is presumably that these Southern European economies have been so poorly treated by the market that they are now cheap. This is what the philosopher Gilbert Ryle named a ‘category mistake’ - something that is so wrong it reveals an underlying misconception. The error is to assume that enough time and movement has passed since the introduction of the Euro for the process of convergence now to be feasible. This was the hoped-for result of tying many of Europe’s economies together in a single currency. Their performance would somehow ‘converge’ one on another and the overall result would be beneficial because that convergence would be on the performance of the Western part of Germany, not on that of say, Southern Italy.
The result has been the opposite and the divergence that has actually happened has been increased by the existence of the single currency. About 40% of the Eurozone’s economic output comes from the more productive countries – Germany and its similar neighbours. The rest come from less productive countries, primarily the Southern members. Germany and the rest have profited from the Euro because their natural competitive advantage has led to gains over the rest that were initially small and generally masked by the general credit-led boom of the period until 2007. Since then, those gains have continued and increased and there is no mechanism to inhibit their increasing strength – the Deutschmark was abolished and so cannot rise against the currencies of Germany’s European trading counterparties and the German central bank was stripped of its rate-setting role so could not increase interest rates to cool things off. Prosperity continued unchecked and started to accelerate.
Meanwhile the Southern countries were discovered to have been gorging on credit and had nothing to rely on when the crunch came. Now, six years into the downturn, Italy and Spain are horribly uncompetitive with the North of the Eurozone and there is no relief available either from currency depreciation or super-stimulative action from a central bank - Germany is the paymaster and won’t allow that. These forces, pushing the German bloc upwards and Spain and the others down are a constant presence, so that when Spain and Italy look cheap compared to Germany, this is just a snapshot part-way along a trend. There is little prospect of meaningful ‘internal devaluations’ that are the new solution to this split prescribed by the new rulers of Europe. It is true that there has been some movement in this direction in Portugal and Spain, but the pace of change is too little to counteract these negative forces still pushing the other way. Still less certain is whether the necessary scale of change is politically possible in the light of general hostility to them from the people who have to live with them – the poor Italians, Spaniards and Portuguese already dealing with mass youth unemployment.
So, let’s look at the picture. This is a chart of the main stock indices of Germany and Spain and the difference between them. They are close enough in raw number for the difference between them to show the trend – they were even the same number (8000) as recently as May, so the gap shows as zero, when those bank analysts started advising us to buy Spain against Germany. It was again briefly zero earlier this month, since when the gap has widened by over 400 points or more than 5%:
Looking even further back, we can see that Spain actually gained ground over Germany in the ‘easy years’ when lavish credit paid for developers to cover Spain’s coastline with concrete boxes. As soon as the crunch started, that went into reverse, with only one bounce in 2009, when the end of the crunch seemed possible. It wasn’t then and neither is it now:
Our constant recommendation in these years has been to buy German stocks and sell those in the Southern countries. We have particularly advised making investments in German real estate, as the most obvious beneficiary of the predictable flow of both people and money that would be attracted to the prosperity that was clustered there. Germany has indeed experienced its first real-estate boom in memory as a result. It hasn’t ended yet and will probably develop into a full-fledged bubble before it does. The poor effect on real estate in the South has been as marked as the beneficial effects on the price of German urban buildings but this is almost impossibly hard to express as a ‘trade’ so we have kept to selling Southern European stock indices instead. Because we also like to identify market turns, this has resulted in a series of recommendations to buy dips in the German Dax whenever we get the appropriate signals and to sell the Spanish, Italian, etc. indices when we get the opposite signals to sell a rally. A few months ago we added France to this ‘sell list’ and, although it has not yet started to behave like one of the Southern group, we believe it will. The weight of the Euro is even heavier on the French economy than on some of the others and this will eventually take its toll. Here is a picture, although this is the German index divided by the French, not a subtraction like the earlier charts:
There has been a steady attrition in the value of France against that of Germany, but no 'cliff edge' moment. We think this is still likely to happen but we cannot tell when. Until that time, the easier profits to be had on the short side will continue to be in Spain and Italy.