Will Europe do the right thing? Via Investing.com

Investing.com — Analysts at BCA Research, in a note, examined a key question: Will Europe do what it takes to revive its economy and solve its problems? However, analysts issue a cautiously pessimistic verdict.

Despite calls for bold reforms from figures such as Mario Draghi, the European region appears destined to continue its decline against its global competitors, particularly the United States, unless radical change is achieved.

At the heart of Europe’s problems is a major productivity gap. Since adopting the euro, the continent has consistently lagged behind the US, with a deficit of 47% GDP per capita (adjusted for purchasing power parity) as of 2023.

The underlying problem is low productivity, which accounts for 72% of this gap, while low labor contributions account for the remaining 28%. This echoes concerns set out in Draghi’s report, which frames Europe as too rigid, too regulated and fragmented across national borders.

This fragmentation, together with insufficient investment in research and development, is leaving Europe behind at the economic frontier.

Europe is a monetary union without a fiscal union, which is at the root of these problems.

The euro ties together economies that are politically and economically divergent, resulting in inconsistent policies, inefficient markets and low levels of investment.

BCA Research remains skeptical about Europe’s ability to adopt Draghi’s reforms, such as simpler regulation, better market integration and a coherent industrial policy. For fear of losing their sovereignty, national capitals hesitate to make the necessary changes.

Although Europe’s illness is obvious, she may not feel compelled to act until the pain is unbearable.

A critical manifestation of this fragmentation is the investment disparity between Europe and the US On both the private and public fronts, Europe is consistently investing less, whether in infrastructure, innovation or capital expenditure.

Compared to the US, where higher investment returns encourage more robust spending, Europe lags behind. The continent’s capital intensity, a key driver of productivity, lags behind that of the US, reflecting the lower rate of investment that characterizes European economies.

As BCA Research notes, this trend is particularly worrisome when examining sectors such as telecommunications, where fragmentation in national markets prevents economies of scale, lower profitability and stifles investment.

While the region remains a leader in green technologies, it has lagged behind in digital technologies such as artificial intelligence, cybersecurity and quantum computing.

These are essential for maintaining competitiveness on the global stage, but Europe’s fragmented markets and underinvestment in research and development are causing it to fall behind.

According to BCA Research, venture capital deals in Europe are 80% behind those in the US, highlighting the continent’s lack of high-risk funding for technological advances and new business ventures.

Draghi’s proposed reforms would require Europe to increase its investment by 750-800 billion euros annually by 2030, focusing on the energy transition, digital technologies, defense and research and development.

However, as BCA Research points out, this goal is unlikely to be achieved. The continent’s political landscape is rife with resistance to deeper integration.

National interests prevail, and countries such as Sweden have already expressed opposition to key aspects of Draghi’s plan, such as issuing joint bonds. Even France and Germany, the EU’s two largest economies, are paralyzed by political indecision, with little hope for significant progress at least until the next round of elections.

The lack of a unified fiscal policy further exacerbates Europe’s challenges. The European Commission’s budget is significantly smaller than that of the US federal government, making it unable to effectively cushion economic shocks or direct large-scale investment.

This is compounded by the absence of a capital market union, which prevents Europe from raising funds effectively.

As a result, countries such as France, Spain and Italy pay higher loan premiums than Germany, leading to further fragmentation and financial instability in times of crisis. Without a more integrated fiscal policy, the continent remains vulnerable to these shocks.

BCA Research warns that structurally, European equities will continue to underperform US equities. The eurozone’s productivity problems and fragmented markets make it difficult for European companies to compete on the same level as their American counterparts.

This trend is unlikely to reverse without significant reforms, which seem politically impossible in the short term. In addition, Europe’s long-term economic prospects are hampered by stagflation – a toxic combination of weak productivity growth and shrinking employment, alongside large entitlement programs that will drive demand far beyond what the supply side of the economy can meet .

This mismatch will fuel inflation, which the European Central Bank may struggle to control, leading to more frequent financial crises and a structurally weaker euro.

However, BCA Research sees some potential for Europe in the short to medium term. Over the next five years, Europe may experience a period of cyclical outperformance.

Global capital spending is expected to strengthen, benefiting European stocks, especially as US tech stocks face a potential downgrade in the coming years. However, these gains would likely be temporary within a broader structural decline.