North And South

By Elwin de Groot, Head of Macro Strategy at Rabobank

North and South

For those who didn’t grow up in the 1980s, today’s Global Daily title refers to the famous mini-series of the early eighties that is set during the time of the American Civil War and is about a friendship that gets caught up in the North-South divide. Although ‘civil war’ couldn’t be much further from the truth when describing the divisions in contemporary Europe, upheavals of tensions have regularly occurred. Through the early days of Eurozone membership, where the Northern member states were accused of having entered monetary union at an advantageous exchange rate, to the heady days of the sovereign debt crisis in which the Southern member states were accused of having mismanaged their economies and government finances.

The US-China trade war, the corona pandemic, the ensuing supply chain disruptions and war in Ukraine, however, all turned out to be a set of unifying shocks for the EU as a whole. It led to the NGEU/RRF funds, the first small steps towards a common industrial policy, and measures to reduce supply chain fragilities as well as a unified approach vis-à-vis Russia.

Although fresh bickering has been taking place over the new EU fiscal rules, there is reason to be more optimistic that a compromise will be found before the end of the year, despite the strong reservations that Germany and several other ‘Northern’ member states expressed about the Commission’s proposals earlier this year. In a joint press conference in Weimar, together with their Polish colleague Magdalena Rzeczkowska, French and German finance ministers Bruno Le Maire and Christian Lindner yesterday argued that they have made some progress overcoming the differences of opinion. These divergences center around the need for stringent and automatic rules to ensure debt consolidation (as sought by Germany et al.) and the need for flexibility and something that fits with new strategic aims (as advocated by France et al.), whilst preserving sound public finances and maintaining the trust of investors.

There are only a few snippets from what had been discussed in detail, but Lindner said that “we need to find the right balance with EU fiscal rules, we need to make the economy ready for climate neutrality and global competition. We cannot finance the past with interest that we must pay – instead, we need to find a way to finance the future […]” Although rather speculative, his comments may hint at a willingness by Germany to allow for more flexibility in the rules for strategic investments. For example, by keeping them out of the budget deficit calculations.

Another reason to expect these matters to be ultimately resolved is that the economic cards have been reshuffled in recent years, suggesting there is a better economic power balance in the EU now. Next to the Polish ‘growth miracle’ (which aptly puts that joint press conference in context) the South of Europe has generally surprised positively with its economic performance, whereas the North, and in particular the German economy, is increasingly showing signs of structural weaknesses. Indeed, if it weren’t for the Southern member states, the Eurozone economy would probably have slipped into a real recession in the previous quarters already. Unemployment in those economies has continued to fall and is now close to, or in the case of Portugal, even below the level it stood at before the sovereign debt crisis hit.

The recent growth pattern also goes some way in explaining the better spread performance since mid-2022, despite rising interest rates. Especially Spain, Greece and Portugal (together good for some 14% of GDP) have performed quite well since mid-2021. To some extent this is because these economies had more room to ‘catch-up’ after Covid-19, given their relatively high share of services, particularly in the food, accommodation and travel sector. A disproportionate sum of funding for investments in greening and digitalization has also worked to the South’s advantage. More recently, though, it is the German economy that has underperformed due to its high industrial sector share, high energy costs and its role in global supply chains, with a large exposure to China. Domestically, a tight labor market has limited Germany’s capacity to expand.

Meanwhile, US data out yesterday only further strengthened the case for a resumption of Fed hikes following this month’s ‘skip’. Durable goods orders for May rose 0.6%. New home sales, also for May, came in almost 100k above consensus, providing further evidence that the housing market is recovering despite Fed tightening. That gels with the overall easing of financial conditions as reflected in the Chicago Fed credit conditions index in recent months and it indicates that Skipper Powell and Crew’s reliance on credit conditions to slow down activity and inflation has not paid off yet. The Conference Board’s survey of consumer confidence for June also improved markedly, with the jobs-plentiful-minus-jobs-hard-to-get measure up again, completing a slew of (second-tier) data that pushed the 10s/2s yield spread to its lowest level since 9 March.