As 2014 commences, the already modest pace of the recovery in the Eurozone will likely be weighed down by the fragmented and undercapitalized banking sector. The accelerating decline in bank lending seen in the data for November (a record low) signals that monetary conditions are continuing to deteriorate. One cause is ongoing deleveraging by companies and households. Weak economic growth is another. Perhaps the most significant cause is the regulatory pressure on banks to improve their balance sheets. Europe’s banks need to continue the process of shrinking their balance sheets and building capital if they are to be able to survive a future financial crisis.
Eurozone banks are continuing to repay their long-term loans to the European Central Bank (ECB). The ECB will be carrying out an asset quality review, which will be based on year-end balance sheets. Thus, banks have likely engaged in some “window dressing” to improve their year-end positions. These effects may be temporary. The review will be followed by stress tests that are likely to be tougher than the previous tests, which many questioned. Some banks will probably fail these tests. The prospects for banks to step up their lending activity in such an environment are not good.
There has been some welcome progress in the Eurozone with regard to the development of a banking union. A significant step will be taken this year with the establishment of a Single Supervisory Mechanism (SSM). The transfer of bank supervision to the SSM will occur in November. Between now and November, the ECB will carry out a comprehensive assessment of the large banks that it will directly supervise.
Progress has also been made on the second and key part of the banking union, the Single Resolution Mechanism (SRM), which will be responsible for handling failed banks. Eurozone finance ministers last month agreed on the structure and funding of the SRM. The European Parliament has rather different ideas about the SRM, and further difficult negotiations lie ahead. Eventually the completed SRM should help reduce the present fragmentation of the Zone’s financial system; and, along with the Single Supervisory Mechanism, it should improve investor confidence in European banks and reduce the banks’ cost of raising needed additional capital. But these improvements will be long-term in nature and not of much help in the coming year.
The Eurozone economy will have difficulty shifting out of low gear in 2014 unless the ECB takes action to ease the current tight credit conditions, for instance by offering banks long-term loans that are conditional on lending to the real sector. The strong euro is another challenge to the economy and to policy-makers. Additionally, continuing very high unemployment makes it difficult for consumer demand to gain momentum.
On a more positive note, survey indicators of economic sentiment in the Eurozone have been improving markedly. Also, the composite (manufacturing plus service sector) Purchase Managers Index for the Eurozone for December was 52.1, up from 51.7 in November, confirming continuation of a gradual recovery, probably at about a 1% annual pace.
The outlook for the Eurozone’s equity markets this year is more positive than the modest prospects for the economy. That certainly was the case last year, when the MSCI Index for the Eurozone markets gained 25.8%, while the region’s economy probably registered zero growth for the year as a whole. We do not expect a repeat of that kind of advance in equities, but high single-digit gains appear possible. We continue to prefer Germany, both because of the nation’s export competitiveness and because the financial sector is a smaller portion (about 17%) of the German market compared with the average for the Zone’s markets (23%). Italy and Spain also are recovering. The smaller, less liquid equity markets of Denmark, Finland, and Ireland have been significant outperformers and are likely to continue to do well in 2014.
Bill Witherell, Cumberland's Chief Global Economist