A Framework for European Transformation

If Europe wishes to maintain the same level of prosperity achieved in the last few decades, a deep transformational journey is required. Geopolitics means that the need for such a transformation is now significantly more urgent. However, macro and micro dynamics also indicate that past growth drivers have run their course, and are now moving in reverse. Still, Europe has a long-established legacy in transforming itself, with capital playing a pivotal role.
Europe needs to address its lack of dynamism. Venture capital across the continent is estimated to be just 0.1% of EU GDP. The absence of large IT-related companies in European equities is a clear indicator that inertia and incrementalism has come at a high cost to investors over the past decade. An added risk relates to a structural difference between demand and supply, leading to suboptimal growth and/or higher inflation.
Any transformation is an ambitious project, requiring significant capital deployment. High debt levels limit what governments can do. The Capital Market Union is an important enabler and, if we wish to avoid future debt-related crises, private capital will need to fill an estimated €250 billion annual shortfalls.
Current regulation (SFDR) favours divestments over transition or transformation. This is a problem for a mature economy such as Europe, as it risks creating economic imbalances and starve healthy companies of economic capital.
The transformation of Europe requires a framework that puts the sustainable investor on a par to the financial investor. Current regulation discriminates against sustainability, thus resulting in long-term capital misallocation.
Europe’s major companies should consider new types of partnerships with asset managers to decarbonise supply chains and permanent carbon sequestration. Large transformative investments may require tax efficient financing in Europe such as the flip structures which exist in the United States.
The long-term nature of private markets is currently better suited for driving European transformation

Foreword

One of the core roles of investment professionals is the analysis of opportunities and risks, which can be divided into the short-, medium- and long-term. Short- and-medium term dynamics often relate to the economy, central banks and market dynamics over the next few years. Generally, the underlying view is one of stable socio-economic systems where cycles tend to fluctuate around central paths and where many measures, such as inflation rates or real economic growth per capita, tend to revert to the averages seen in the past. This type of business cycle analysis is very different from taking a ‘long-term’ view, where the focus is on how, why and when the structures of complex socio-economic systems change over time.

To observers purely focused on the short-term, such structural changes tend to appear sudden, unexpected and, depending on their economic impact, often destabilizing and even shocking. In reality, they are more often than not the results of complex trends and emerging patterns that have established themselves over a prolonged period of time. With the benefit of hindsight, “Everything is obvious, once you know the answer”, as highlighted by the title of an influential book on the frailties of human forecasting^[1].

Examples in global politics and finance abound, from Russia’s latest invasion of Ukraine, to Brexit, the Euro crisis and the 2008 Great Financial Crisis. But also the stunning outperformance of the U.S. equity markets post the 2008 Great Financial Crisis, when most were expecting its demise vis-à-vis emerging markets. Each of these events took many market participants by surprise and was deemed un-forecastable.

In each of these cases, however, a more attentive analysis pointed to plenty of warning signs well in advance, easily visible to the attentive eye. To take the example of the U.S. housing bubble that triggered the 2008 crisis, economist Paul Krugman argued as early as August 2005 that the U.S. economy had become dangerously dependent on rising house prices: “Now we're starting to hear a hissing sound, as the air begins to leak out of the bubble. And everyone (…) should be worried.”