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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-weekly Geopolitical Report. I'm Phil Adler. Europe's potential as an investment destination appears bright, but realizing that potential depends on how the continent responds to the new geopolitics and the military threat from Russia. Confluence Chief Market Strategist Patrick Fearon Hernandez joins us today to focus on a key region where Europe is vulnerable, the Baltics. Patrick, give us a thumbnail on exactly why Europe has not been an attractive location for investors in recent years.
Patrick Fearon-Hernandez:Well, hi, Phil. Thanks for having me on your program. To answer your question, much of the problem for Europe has been linked to stagnant economic growth and declining competitiveness. That can be traced to a range of structural economic headwinds such as excessive taxation and regulation, weak capital markets, and timid industrial policy, all of which discourage innovation and investment. Other structural issues include slow population growth, high public debt left over from the global financial crisis, weak consumer spending, and high energy costs after Russia's invasion of Ukraine.
Patrick Fearon-Hernandez:Finally, the EU's consensus driven political institutions and political polarization in its member countries are widely recognized as impediments to effective policy making. Finally, while these economic issues have held down European stock prices and made European stocks relatively cheaper than US stocks, that hasn't sparked heavy buying because The US stock market is so dominated by growthy, exciting technology firms that investors love these days. This is why it's been so challenging for European equities in recent years.
Phil Adler:Well, your thesis is that this stagnant situation is now changing. That as The United States withdraws from its role as world defender of democracy and Europe spends more on defense, investment opportunities will be created there. But a lot could go wrong if Europe doesn't meet the defense challenge. You identify the Baltics as an area to keep a close eye on. How did the addition of Finland and Sweden to NATO last year change the temperature in the Baltic region?
Patrick Fearon-Hernandez:Well, as I noted in my report, adding Sweden and Finland to NATO boosted the alliance's military position in the Baltic. Indeed, you could easily make the argument that the Baltic Sea is now essentially a NATO lake, a lake that Russian naval and commercial ships have to traverse to get to the Atlantic Ocean. Of course, Sweden and Finland also have credible land forces, but the key change for NATO has been the alliance's enhanced control over the Baltic Sea.
Phil Adler:So we can say that new NATO members, Finland and Sweden, add to Europe's defense capabilities?
Patrick Fearon-Hernandez:Yes. I think that those countries have undoubtedly added to NATO's ability to deter Russian aggression and win a potential conflict with Russia if it comes to that.
Phil Adler:We'll have these new members of NATO diminished the threat from Russia.
Patrick Fearon-Hernandez:Well, that gets to the crux of the matter. As I argue in my article, the accession of Sweden and Finland has augmented NATO's position in Northeastern Europe, so it has reduced the Russian threat to some extent. However, it hasn't eliminated that threat. The NATO states on the southern shores of the Baltic Sea are still quite vulnerable to a Russian military invasion, pressure, or sabotage as are other NATO countries in Eastern Europe. And given that Moscow has proved so aggressive with its invasion of Ukraine and given that the Trump administration seems so intent to reduce The US defense commitment to the continent, we think European leaders are quite worried about Russian aggression in the Northeast.
Phil Adler:Patrick, we think of Russia as weakened from its losses in Ukraine. Is it?
Patrick Fearon-Hernandez:In many aspects, yes. Russia has lost enormous numbers of troops in the majority of some of its key weapon systems. But in other aspects, Russia is holding up well and has even gained power. For example, after learning from its mistakes early in the war, the Russian armed forces now include huge numbers of battle hardened troops who know how to fight in a modern war with modern weapons, such as drones. Russia has also boosted their defense industrial production, and it's broadened its access to key weapon systems from its allies, such as China, Iran, and North Korea.
Patrick Fearon-Hernandez:If president Putin decides to gamble someday, we think he could well decide to use his forces against Europe. You simply can't discount that possibility.
Phil Adler:Patrick, how has Europe responded in terms of defense spending to the Russian threat?
Patrick Fearon-Hernandez:Well, in response to US pressure and the threat of further Russian aggression, many European countries have pledged to sharply increase their military out outlays in the coming years. For example, the German government has hinted it will loosen its fiscal rules to hike its defense budget to as much as 5% of gross domestic product. That would be 2.5 times the current NATO target. And to facilitate such increases, the European Union has relaxed its fiscal rules for member countries and is implementing a €150,000,000,000 centralized loan fund under which EU countries can borrow for joint arms purchases. Purchases.
Patrick Fearon-Hernandez:As we've written in many of our articles, the Europeans really are boosting their defenses again.
Phil Adler:Well, is the increase in European defense spending so far adequate?
Patrick Fearon-Hernandez:Well, so far, no. While big plans are already in place for a lot of countries, it takes time to radically shift state budgets. For example, even if they threw a lot more cash at arms purchases right now, their defense industry may need years of additional investment to be able to produce everything that's being ordered. In other words, we think there's still a long runway for the rise in European defense budgets.
Phil Adler:And, Patrick, how might increased defense spending trickle down to the rest of the European economy?
Patrick Fearon-Hernandez:Well, in my view, that's one of the most exciting things happening in Europe today. Besides strengthening NATO's military capability over time, these defense spending increases could provide near term fiscal stimulus to the broader European economy. Just as important, we think they could potentially promote increased investment and innovation across the European economy over the longer term.
Phil Adler:Does Europe have plenty of room to increase borrowing to support new defense spending?
Patrick Fearon-Hernandez:Well, that is an important issue. As in The US, a lot of European countries have seen their debt loads increase over time, and there's a lot of pushback against further debt increases from some quarters. All the same, if higher defense spending really does help spur stronger economic growth in Europe, the overall debt as a share of GDP may not increase that much. If growth strengthens sufficiently, it could conceivably even decline. As in any economy, stronger growth solves a lot of problems.
Phil Adler:Patrick, could you review now some of the key obstacles remaining that prevent a vibrant European economy?
Patrick Fearon-Hernandez:Well, really, it's still the list of big long lasting structural problems that we discussed at the beginning of our talk. Things like high taxation and regulation, fractured and weak financial markets, and poor innovation and productivity growth. Again, we feel pretty comfortable that the near term increases in European defense spending and infrastructure investment will lead to at least a short term boost to economic growth. And those changes have also the potential to boost economic performance over the longer term. But those longer term benefits are still only speculative.
Patrick Fearon-Hernandez:The jury's still out on whether they'll actually be as positive as I think is possible.
Phil Adler:Well, it seems there's a lot to be uncertain about. How does Confluence Investment Management currently rate Europe as an investment destination?
Patrick Fearon-Hernandez:Despite the uncertainty about improved growth over the longer term, we do see positive trends in European stocks right now. In part, that's because of the short term stimulus provided by higher defense spending infrastructure investment. In addition, the dollar's been declining recently, which is typically positive for foreign stock returns in general. Also, the low stock valuations in Europe and a potential global rotation toward value stocks would argue for putting more cash to work on the continent. Indeed, that sentiment is reflected in the second quarter adjustments to our asset allocation portfolios where we reintroduced exposure to foreign developed stock markets after having none in the previous quarter.
Phil Adler:Finally, are you optimistic that Europe will in fact take the steps necessary to protect its borders and revive the economy there?
Patrick Fearon-Hernandez:Well, among those of us on the macro team or on the asset allocation committee at Confluence, I'm probably the most optimistic about Europe. However, as I've noted, I'm not arguing that a stronger, more competitive European economy is a sure thing in the longer term. I see a good chance of that happening, but lots of things have to happen from sustaining the increases in defense spending and investment in infrastructure to deregulating and reforming Europe's capital markets.
Phil Adler:Thank you, Patrick. This week's report is titled NATO's basic vulnerability implications for Europe. You can find a link to the written report on the Confluence Investment Management webpage, confluenceinvestment.com. Today's discussion is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security.
Phil Adler:Our audio engineer is Dane Stole. I'm Phil Adler.