Wirecard was thought to be Europe’s ‘New Economy’ champion. Was the fintech giant’s collapse into bankruptcy last week symbolic of a wider problem for the European economy?  This week I examine two reasons why COVID may be about to amplify the threat to Europe’s economic outlook.

The confidence of the capital market in the company I have been managing for 18 years has been deeply shaken.

Markus Braun, former CEO, Wirecard, June 2020

I built the greatest economy in the World, the best the U.S. has ever had. I am doing it again!

Donald Trump, US President, June 2020 (via Twitter)

America is not a country, it is a world.

Oscar Wilde, Irish Poet, 1854 – 1900

Wirecard was Germany’s answer to Paypal, and CEO Markus Braun was its version of Steve Jobs, complete with black turtleneck and a reputation for being a visionary, if demanding, genius. So now that Europe’s flagship fintech has become the first member of Germany’s DAX index to go bankrupt in its 30-year history, it is perhaps unsurprising that there is some soul searching to be done.

What makes the Wirecard scandal so painful in Germany, and in Europe, is that it highlights Europe’s relative weakness in the technology sector, especially compared to the dominant position of the US.  Germany has had other recent financial scandals (Siemens, Volkswagen), but these were in sectors where Germany was, and is, a global leader.  As software continues to eat the world, it will become increasingly difficult for Europe to maintain its economic position in the global economy if it cannot compete in technology, and the Wirecard scandal just reinforces how much work there is to do.

Europe is having a ‘better’ crisis (for now)

Conventional wisdom suggests that the COVID pandemic will have a disproportionately negative impact on the US economy due to its poor handling of the crisis itself.  The statistics do not lie. When compared to Europe (maybe excluding the UK and Sweden), Europe is doing much better.  In the US, new cases are rising, death rates are higher, and the attempted re-opening of the economy has been aborted in several states and cities. 

In Europe, the opposite is true.  Both new cases and death rates have fallen dramatically, enabling much of Europe to begin re-opening, even in areas like international travel.  In fact, Europe’s anticipated decision to re-open its borders to international travel to everyone except Americans is a stark illustration of Europe’s superior response to the crisis.

However, over the long term the US may win anyway

While Europe may win the battle, the outcome of the war is far less clear.  Yes, in the short-term, Europe’s ability to open up more quickly will help their economy.  However, the COVID crisis will likely accelerate two trends which, over the longer term, will lead to its relative decline (at least compared to the US).

 The (continued) rise of technology (and the importance of sectoral specialization)

The German newspaper Handelsblatt published a fascinating article last week entitled ‘Companies in comparison: USA increasingly stronger – Europe is falling behind’.  The article looked at how, and why, US companies have performed so much better than European ones over the last decade (Chart I) and why the COVID crisis will likely exacerbate this trend.

Chart I: S&P 500 (black), Russell 2000 (green) vs STOXX 600 (orange) and EURUSD (purple), % return since 2008 (in USD)

Source: Bloomberg

While the S&P 500 has increased by over 135% since 2008 (and even the Russell 2000, which ignores the highly concentrated effect of the FAANG stocks, has gone up by about 100%), the STOXX 600 has actually declined by over 10% (in USD terms) over the same period.

US corporate outperformance is also evident in earnings.  In 2019, the 500 largest European companies saw earnings decline by 8%, to €505 billion.  In contrast, the largest 500 US companies generated earnings of €750 billion, an increase of 4% from 2018 (and a staggering outperformance of almost 50% compared to their European counterparts).

One of the main reasons why US companies are more successful is because America is the world’s largest centre of innovation, spending almost half a trillion dollars on research and development, more than Europe, Japan and South Korea combined.  This focus on innovation means that the US largely dominates the digital economy, while Europe specializes in ‘old economy’ sectors like manufacturing and industrial production. Not that there is anything wrong with these sectors, but they are less profitable and harder to defend against competition from China and other emerging economies.  

The COVID crisis will likely exacerbate the dominance of the digital economy, extending the inherent advantages of the US over the EU in economic terms.  In the first quarter of 2020, the total earnings of the top 500 European listed companies was €11 billion.  This is about the same as the first quarter earnings of Apple alone. It is little wonder why the EU is so keen on a new digital tax!

The decline of international trade

In addition to the rise of technology, the other major trend that many predict will result from the COVID crisis is a decline in international trade, at least in terms of physical trade and complex international supply chains. 

The European economy, with its large current account surplus, is highly dependent on international trade. Furthermore, it is their large trade surplus which provides support to the euro, with the currency rising and falling along with the size of Europe’s surplus (see Chart II).

Chart II: Eurozone Current Account (€ billions, blue) vs EURUSD (orange)

Source: Bloomberg

Should the ‘reshoring’ trend take hold, Europe will be disproportionately negatively impacted (along with China).  As Stefan Kooths, economic director at the Kiel Institute for the World Economy is quoted as saying in the Handelsblatt article referred to above, the reliance on exports is “the Achilles heel of the German economy”.

Economic trends should support the US dollar, but…

COVID did not cause the digitization of the economy, nor did it reverse the economic trend of globalization (see Brexit and Trump!). Similarly, the crisis did not cause the collapse of Wirecard, although, like Enron in 2001, a financial crisis is often the catalyst for the uncovering of alleged fraud.

So, just as Wirecard would have collapsed eventually, it is likely that increasing technological innovation and peak globalization (at least in a physical sense) would have continued to see the US economy outperform that of Europe in the coming years.  COVID will likely just reinforce this momentum, which (in the absence of outside interference) would justify the US dollar’s premium versus the euro (about 10% – 20% in fair value terms).  However, the ‘outside interference’ caveat may be an important one.  I will address this directly next week!

Author: Kevin Lester