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Oversold euro area blue chips are a screaming buy

Cultura RM Exclusive | Philipp Nemenz

An equity index tracking the euro area's 50 world-beating companies was down 17.4 from a year earlier on Friday.

No rational argument of economic analysis can justify that. Here is why.

The euro area market is awash in liquidity. And that won't change anytime soon. While criticizing the governments' economic policies, the ECB is clearly implying that its printing presses will remain in overdrive for the foreseeable future. Unlike his Fed colleagues, the ECB's President Mario Draghi is not dancing a hesitation waltz in Frankfurt.

Recovering from Germany's disastrous fiscal austerity diktat, the euro area economies are moving up on the wave of cheap and abundant credit flows. In the first quarter of this year, the area's GDP grew at an annual rate of 1.7 percent. That is a slight acceleration from a 1.5 percent pace recorded for last year as a whole and twice the growth rate in 2014.

The ECB is front and center

Almost all of the growth in the first three months of this year is accounted for by demand components – household consumption and business investments -- that are mainly driven by cheap credit and expectations of stronger sales. These two variables contributed 1.6 percent of GDP growth.

That shows that the ECB's liquidity is connecting with the real economy, in spite of an apparently gun-shy banking system that is still channeling most of its lending to sovereign borrowers. Banks are rebuilding their capital base after long years of recessions and slow recovery. But once that process is finished, banks will return more vigorously to their core business of lending to firms and households.

Here is how that adjustment process is unfolding at the moment. Last April, the euro area's lending to the private sector was only 1.2 percent above its depressed year-earlier levels, but lending to governments was accelerating to an annual rate of 10.4 percent.

The fact that banks' return to a stronger funding of the private sector is so slow is sad testimony to the huge damage that major euro area governments – primarily France and Italy – did to their economies by allowing themselves to be maneuvered into German fiscal austerity nostrums.

It is pleasing to see that this disaster is being overcome, but it is clear that the weak bank lending to the private sector, and a price deflation of -0.2 percent in April, leave no alternative to the ECB's monetary expansion, despite relentless attacks and pending lawsuits from the bank's German constituency. [Germany's Constitutional Court, the highest court in the land, will rule on the latest German complaint against the ECB on June 21, 2016.]

Meanwhile, the ECB's supportive policies, and the prospect of stronger euro area growth, are positive signals for the area's stock market values in a grotesquely oversold environment.

Additional positives are that France, Italy and Spain – one-half of the euro area economy – are rejecting German efforts to re-impose fiscal austerity and socially unacceptable structural reforms via the Brussels EU Commission and the Eurogroup (a forum of euro area finance ministers).

Ignoring Germany

Squeezed from left and right, the beleaguered French president (currently polling at about 16 percent) is turning a deaf ear to pressures from Brussels to cut public spending. And neither is he rushing to push through Brussels-mandated new labor laws (i.e., part of structural reforms) that have caused widespread protests ("Nuits Debout," massive nightly demonstrations on the Place de la République in Paris for more than two months now), paralyzing strikes in the country's transportation system and huge sanitation problems of uncollected garbage piling up on Parisian streets.

Brussels and its "leaders from behind" are oblivious to the fact that the French people are overwhelmingly rejecting orders that would kill the incipient economic recovery and employment growth. They are also blind to the dramatic decline in the French support of the EU; only 38 percent are now favorable to the EU, compared with 70 percent about ten years ago. And, as a likely prelude of things to come in France, about a third of the French also consider that Brexit is a good thing.

Italy, too, is ignoring Brussels opposition to tax cuts as the prime minister seems determined to support the economic recovery and job creation. The government is under pressure from political opponents in local elections currently under way. In a highly symbolic political defeat of the governing (Social) Democratic Party, the mayor's office in Rome is likely to go next Sunday (June 19) to the Five Star (M5S) political party founded by the comedian Beppe Grillo.

Apart from that, Italy's stronger economic growth and declining unemployment are preconditions for fundamental political reforms on which the prime minister has staked his job.

Austerity is also out of the question for Spain as the country faces a new round of elections on June 26. At the moment, the polls indicate no clear winner. There is a possibility of a grand coalition of the shrinking Socialist Party and the caretaker center-right Partido Popular (PP). But there is also a possibility of a leftist sweep, led by a new coalition of Unidos Podemos ("Together We Can").

Either way, Spain will continue to focus on growth to fight poverty, affecting more than 20 percent of its population, and social exclusion, indicated by nearly 11 percent of its jobless people who are becoming practically unemployable (i.e., people unemployed for several years). That compares with only 1.9 percent of long-term unemployed in Germany.

Chances are also that Germany could lay off the rest of the euro area. The German government is in tatters. The coalition CDU and the Bavarian CSU center-right parties are barely on speaking terms, while the SPD Socialists seem increasingly impatient with Chancellor Merkel. All that will get worse if, as seems very likely, the chancellor's migrants deal with Turkey were to fall apart.

Under these circumstances, Germany's political clout and its ability to impose policies on other euro area countries are very much in doubt. I also hope that the ECB, or some of the presidential candidates in France, will summon the courage to call out German economic policies. Somebody has to tell the Germans that they are destabilizing the monetary union with their mega trade surpluses of 8 percent of GDP. To remedy that, Germany needs to run a much stronger domestic demand so that the hard-pressed euro members can sell it something. That would be an appropriate response to Berlin's constant hectoring.

Investment thoughts

The euro area world-class blue chips are grossly oversold.

Here are a number of key investment issues to consider.

The monetary union's growth dynamics are supported by the loosening fiscal policies and a huge liquidity provided by the ECB.

Budget deficits are down to 2 percent of gross domestic product (GDP), primary budget surpluses (budget before interest charges on public debt) are close to 2 percent of GDP and the gross public debt is declining.

The annual growth of unit labor costs has slowed to about 1 percent and seems firmly on a downward trend. That will underpin rising profit shares in a growing economy.

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