Will Europeans Be Eating Our Lunch?

Will the Europeans Be Eating Our Lunch? October 19, 2009   Bill Witherell, Chief Global Economist

The converse of the title above was asked by Business Week when the former socialist government in France introduced the 35-hour week.  As an American living in Paris at the time, this writer agreed that France and much of the rest of the Eurozone appeared likely to fall increasingly behind the US in the competition for global markets.  Several recent developments in Europe and policy trends in the US, however, cause us to question that view. The US risks losing its competitive edge as Europe adopts more business-friendly policies, while Congress appears headed in the opposite direction.

Two notable developments were in the tax area.  At the end of last month, French President Sarkozy, in a move described as a “competitiveness shock,” announced scrapping of the “taxe professionnelle,” which was a local business tax levied on fixed investment. This move to give a 12-billion-euro tax cut to business comes despite the fact that France has one of the highest structural deficits in the eurozone.  This is only one of a growing number of economic reforms under Sarkozy.  The 35-hour week has essentially been buried.

In neighboring Germany, the largest economy in Europe, the new center-right government is also moving towards business tax reductions as well as pro-business bureaucratic reforms. Also, while it may well prove necessary to increase social security contributions, any such increase will fall totally on taxpayers, not on employers.  Of course, in both countries the reform process has much further to go, but the direction is clear.  Governments in both countries are seeking to improve the international competitiveness of their businesses in order to encourage investment and job creation. We look in vain for similar action in Washington, or even recognition of the fact that US companies face some of the highest taxes in the group of advanced economies.

The other notable development was in the trade area.  On October 15th, the European Union and South Korea signed a landmark free-trade agreement covering the approximately US$90 billion of trade between the 27-member EU and South Korea, which is projected to increase by some 20% as a result of the deal.  South Korea committed to eliminate 99% of its tariffs over a three-year period and a number of its non-tariff trade barriers, as well as to liberalize its telecommunications, environmental, legal, financial, and shipping sectors. The EU will eliminate 96% of their tariffs. The deal still has to be ratified by the 27 member states and the European Parliament, as well as the South Korean Parliament.

The previous administration in the US reached a very similar agreement with South Korea in 2008 – indeed, it appears that our negotiators did much of the heavy-lifting in preparing for such a deal with Korea.  Very unfortunately, our Congress in its wisdom has yet to ratify the deal. While the Obama administration has said it will push for ratification, the President has expressed his lack of enthusiasm for free-trade agreements. He has expressed concern that the pending U.S -Korean deal could have an adverse effect on our auto industry.  Now it is European auto manufacturers that should find increased opportunities in the Korean market. One can only hope that the specter of European companies gaining a competitive advantage over US firms in trade with this important Asian economy will wake Washington up.

We recognize that taxation and trade are only two of the numerous factors affecting the international competitiveness of US companies.  Our more flexible labor markets, for example, will likely prove to be an important advantage as the respective economies emerge from the recession.  US firms have had much greater leeway to cut back on labor costs than has been the case in the EU, and far more than in Japan. This will have a strong positive effect on productivity in the near term. Nevertheless, we are concerned to see opposing policy trends in Europe and the US that will have important market implications if not reversed.

The effects of these policy trends on the relative ability of U.S., European and Korean firms to compete in global markets will come into play in the medium and long term. We have been adding recently to our European positions in our international ETF portfolios.  Recovery in Europe progresses, but it still appears to be lagging the U.S. economy. In the case of Korea we are slightly underweight as the Korean won has been the strongest currency in emerging Asia – which hurts exports.

We use the iShares MSCI South Korea Index ETF, EWY, to obtain exposure to the Korean market.  So far this year, this index is up a healthy 63.3%, only slightly below the MSCI Emerging Market increase of 70.4%.  However, this month Korea is off by a little over 1% whereas the Emerging Markets as a whole are up a further 5.7%.  This pull-back in Korean equities may be short-lived. We are paying particular attention to Korea’s technology exports as information technology accounts for 29% of the EWY ETF. The Korean firm Samsung alone accounts for 21.3%. As the global economic recovery gathers pace, technology exports will likely accelerate.

Cumberland Advisors is registered with the SEC under the Investment Advisors Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in states and/or international jurisdictions where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services.

Please feel free to forward our commentaries (with proper attribution) to others who may be interested.

For a list of all equity recommendations for the past year, please contact Therese Pantalione at 856-692-6690,ext. 315. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.