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Industrial production Unemployment rates - core vs. periphery Index, 100 = January 2007 Percent, Peripheral rates weighted by population 41 18% ie — Greece, Ireland, Spain & Portugal 16% 105. 14% 100 17% in 10% od a 85 6% Germany ad Ao, | se ee ee Se eel a 2007 2008 2009 2010 2014 0% a ae 7 Source: INE, CSO, ISTAT,NSS, Eurostat, Bundesbank, J.P. Morgan Ve7O 18S TG 18S TO 18D ZO aT Securities LLC, J.P. Morgan Private Bank. Periphery =Portugal, Ireland, lialy, Source: J.P. Morgan Private Bank, Bankof Spain, Bankof Portugal, OECD, ‘Greece, Spain. CSO, M55, Bundesbank The third concern: Germany as paymaster. We are often told that Germans across both major parties are unflinching supporters of the European project, and will do whatever it takes to prevent a break-up. The objections from members of the Bundesbank are described as lonely voices of opposition that carry no weight [a]. But how large are the costs going to be? German politicians and voters may see current circumstances as exceptional, and that if they just agree to one more package, the problem will go away. However, we are starting to see analyses of how costly a permanent transfer union may be for Germany. Bernard Connolly at Hamiltonian Advisors sent me a recent paper from the Centrum fur Europaische Politik in Freiburg, which provides some clues. They see three alternatives for the deficit countries: ** massive reduction in regulations and unit labor costs to regain competitiveness ** exit from the EMU, re-introduction of national currencies ** permanent transfer union from surplus countries to deficit ones On the last option, they estimate a “creditworthiness gap” in European deficit countries of Eur 108 billion in 2010. The gap measures how much European deficit countries rely on capital inflows to fund consumption, rather than investment (which contributes to future GDP). Germany’s share of the European surplus is around ™%, so let’s assume a pro-rata burden on Germany to maintain the transfer union. As a result, the theoretical economic cost could be 3.3% of German GDP every year, which as shown, gets close to some expensive episodes in German history. If German citizens were faced with costs this high, it could be a White Castle hamburger-throwing moment of national proportions. ior ev Europe equities, priced for the risks ico ofmelor events Europe 10-yrbvalling PE divided by US 10-yr trailing PE 45% 125 4.0% 3.5% 15 3.0% 1.05 2.5% 2 OM, 0.95 1.5% _ 10% 0.65 5% O75 0.0% Peak Versailles. Unificaban (singe PotentialcostofEMU = gas reparations (1925) 1991) transfar union 1998 2000 ann 2004 2006 2008 anid Source: Carl-Ludwig Holtirerich, Hallelnstitute for Economic Research, Source: Factset, MSCI. Zentrum fur Europaische Politik (Freiburg), J.P. Morgan Private Bank. Bottom line. At atime when European equities are trading close to 2009 lows relative to earnings and book value, this package could result in a relief rally for European equities, particularly banks. The chance of a disorderly default in 2011 has decreased markedly, and a process has been put in place to create more seamless transfers to areas (and banks) in need. But the size of the transfer union fund is not big enough to allay all concerns, particularly with Spain and Italy growing at anemic levels, and there is execution risk in Greece. HOUSE_OVERSIGHT_025218