In-between the lines
- This week's correction was the first real setback in this year's equity rally
- Not all is fine in Euro land, but the rally is probably not yet over
- While market confidence recovers, most of the real adjustment still lies ahead
- East Germany's integration with the West shows what is still to come
European equity markets experienced their first meaningful correction this year. On Tuesday, European stock markets lost on average over 3%. Between last week Thursday and this week Tuesday, the Dax and the EuroStoxx50 fell by 4.3% and 4.1% respectively. The correction is modest compared to last year's experience and markets have already recovered some losses.
Nevertheless, it is the first real break in the stellar performance so far this year and has raised questions whether the rally is over. The correction has been triggered by a number of factors of which three stand out:
- Premier Wen Jiabao's announcement that China has cut its growth target for this year to 7.5%;
- Renewed worries that Greece's debt restructuring with private creditors may run into difficulties;
- Concerns that the conflict with Iran may escalate and have severe implications for oil supply.
The last point is a real risk and has the potential to derail the rally for good if the conflict leads to military action.
Concerning the first two points, however, markets have overreacted. The real message from Wen Jiabao is not that China is in trouble but that inflation has been tamed and that policy can now refocus on growth and employment. This shift has already started at the end of last year and is to continue. On the Euro side, reports from banks and insurance companies suggest that Greece will have at least 75% voluntary participation in the debt exchange. If support falls short of the 90% target, Greece will most likely activate the collective action clause, which should not come as a surprise.
Labor market adjustment has only just started
The recovery in financial markets so far was driven by signs that global growth conditions are improving after last year's downturn and that the Euro debt crisis is not spiraling out of control, thanks in large part to the ECB's liquidity support. In our judgment, these developments have still momentum left and will drive markets higher.
The real adjustment in the Euro area, however, has only just begun and is likely to have deeper implications than markets and policymakers are currently anticipating. In particular, not fully appreciated is the likely labor market fallout, for which East Germany's integration with the West provides an insightful case study.
East Germany's integration revisited
The generous terms of monetary union, the decision to adjust wages to West German levels as fast as possible and poor productivity standards boosted East German real unit labor cost by more than 50% after unification.
The result was an almost immediate collapse in production and a 25% decline in employment in the first two years after unification. Productivity improved after a couple years, but not rapid enough to restore competiveness. In response, employment fell further. By the late 1990s, the unemployment rate reached nearly 20% and more and more people moved to West Germany to find a job.
The situation only stabilized in 2005. Employment has risen modestly in recent years and the unemployment rate declined to about 11%. However, much of the dislocations are irreversible. Employment in the east is 40% below the pre-unification level, while employment in the west rose by 20%. The population in the east declined by 3% and in the absence of large annual fiscal transfers would probably have fallen further.
In contrast, the population in the West increased by 6%.
Lower wages and more migration
The regional competitiveness gaps within the Euro area build up over time and came not as a sudden shock, but the implications are similar to the case of East Germany.
In the ten years prior to the financial crisis, Germany became 30% more competitive, while the periphery lost about 15%. The gap increased during the financial crisis and narrowed only a bit during the recovery.
Unemployment has doubled in response and keeps rising.
Interesting are the divergences. Ireland has made the most progress in reducing the gap with Germany and its labor market is stabilizing, albeit at a high level of unemployment. Spain has also reduced the gap to Germany, but that has not been enough to stop the rise in unemployment. Greece, Italy and Portugal have so far made no meaningful progress.
With less of a fiscal transfer cushion, the labor market adjustment to come is likely to require more flexibility than in the case of East Germany. Wages in the periphery will have to fall, certainly in real terms but probably also in nominal terms. That is already the case in Ireland and is implied in the latest Greek restructuring plan. However, can labor costs be sufficiently reduced to restore pre-crisis employment? Probably not! On the other hand, the periphery cannot count on generous fiscal transfers as in the case of East Germany. The result is most likely increased migration to the core, especially Germany.
First figures already provide evidence for this emerging trend. Germany may benefit from these developments, but the political implications will be challenging.
Silvia Quandt & Cie. AG
Silvia Quandt Research GmbH, Silvia Quandt & Cie. AG, and its affiliated companies regularly hold shares of the analysed company or companies in their trading portfolios. The views expressed in this analysis reflect the personal views of the analyst about the subject securities or issuers. No part of the analyst's compensation was, is or will be directly or indirectly tied to the specific recommendations or views expressed in this analysis. It has not been determined in advance whether and at what intervals this report will be updated.