March 12, 2019
As recently as December 14, 2018, European Central Bank President Mario Draghi stated that the ECB would stop the almost $3 trillion quantitative easing (QE) bond-buying program in January 2019. At that time, Draghi lowered his prediction of Europe’s growth for 2019 to around 1.7%, citing the persistence of uncertainties related to trade issues, the threat of protectionism via Brexit, vulnerabilities in emerging markets, and a steep decline in asset valuations within financial markets that would impact spending.
Fast forward just three months to March 7, 2019 and Draghi has put out a revised forecast for only 1.1% growth in 2019 – cutting in half the ECB’s outlook from just a year ago. At its policy meeting, the ECB announced that they will postpone their first post-crisis rate hike until 2020 and went on to state that the central bank will now offer “ultra-cheap” loans, saying again that the global trade war and the threat of Brexit are causing lasting damage to the euro-zone economy. Brexit hasn’t even happened yet, but their pointing the finger at the U.K. seems like a good way to lay blame somewhere other than where it lies.
What’s interesting is that Draghi forgot to mention the biggest threat to Europe’s GDP growth – namely, the irreversible, structural long-term damage from embracing socialist economic policies that fueled a flood of non-assimilating immigrants and massive public spending on top of sky-high income tax rates.
High marginal tax rates can make additional work prohibitive and lead individuals to decide to stay in less productive positions or choose not to work at all, depending on how favorable the social safety net is in their country. When high tax rates increase the cost of labor, this has the effect of decreasing total hours worked, which decreases the amount of production in the economy.
The intensely liberal European Union is headquartered in Brussels, Belgium, a nation with one of the three highest marginal tax rates in Europe at 60.2%. The higher two are Slovenia (61.1%) and Portugal (61.0%). Here’s the scary part: Those 60%+ marginal tax rates kick in at household incomes of just $56,000 in Belgium and $107,000 in Slovenia. Really? Tax rates reach 60% at such modest incomes?
The youth unemployment rate in Belgium has averaged 20% from 1983 until 2018 (source: Trading Economics), and this is the “democratic socialist” model which those elitists that run the EU in Brussels want to apply to greater Europe. No wonder the U.K. wants out. In terms of share of eurozone GDP, Germany is #1, as it contributes 21.1% of euro-GDP with the U.K. coming in second at 16.0%. No wonder Brexit is such a big deal. Brexit takes a huge chunk of revenue away from the socialist elites.
If you want to take into account the countries that matter most to the Eurozone, Germany has a top marginal tax rate of 47.5% for incomes above $299,000, France has a top marginal tax rate of 55.1% for incomes over $583,000, Spain has a top marginal tax rate of 43.5% for incomes over $73,000, Italy has a marginal tax rate of 52.8% for incomes over $93,000, and the U.K. has a marginal tax rate of 47.0% for incomes over $192,000. That’s quite a wide range of top rates and peak income thresholds in one region.
European Growth Forecast – “Look Out Below!”
So, while the benchmark Euro Stoxx 50 index has rallied in tandem with the U.S. market since late December, the downside risk to European equities now seems elevated. Germany closed 2018 with GDP growth of only 1.5% compared with 2.2% in 2017. This is the weakest growth rate in five years, with downward momentum implying economic contraction for Europe’s most important economic engine.
It’s no surprise, then, that Draghi is raising a red flag before the first quarter is even in the history books. Germany’s factory orders were down -2.6% for February and poor import and export data out of a key market in China shaved -4.4% off the Shanghai Index. Not knowing what is in store for Brexit, there is little to get excited about in the way of owning European equities.
The hard data is telling us that the recent gains enjoyed by the Euro Stoxx 50 index will be at risk of being wiped out as the year progresses. Those expected losses could be led by the European banks, now that the ECB will reintroduce the long-term financing operation for banks, known as TLTRO.
With no rate hikes in the current forecast, loan demand in decline, and trade/tariff talks hitting a stalemate, European financials could suffer worsening business conditions over the intermediate term. Additionally, it’s hard to imagine how much lower interest rates can go in Europe. As of March 7, the ECB held its benchmark refinancing rate at 0 percent, and as of last Friday the average eurozone 3-month interest rate was -0.31%. Most 10-year bond rates in the EU nations have gone down 15 or more basis points in the last month, and 30-60 bps in the last year:
This table represents the most widely-held and widely-traded 10-year government bonds from around the globe. If $3 trillion in QE, zero interest on short-term money, and 1.0% 10-yr money can’t get Europe’s economy out of first gear, then I’m not sure what will. While this situation – combined with a weakening economy in China – may not wash up on U.S. shores anytime soon in the form of weak domestic data, it could well have a dampening effect on investor sentiment.
Despite the rising chorus of socialist nostrums in the U.S., our citizens, voters, and investors need look no further than Europe to see how decades of experiments in social democracy are working out. Capital will continue to leave places where it is not welcome and move to where it is not perfectly welcome but is treated with more respect than on a continent with 60%+ tax rates.