Mike Jennings

Papers White Paper

Europe – the road ahead

White Paper

TT considers a recent string of poor data in the Euro area and asks what opportunities this may throw up.

“The cavalry are coming”. That was the big cry in 2012 when US and international investors were big buyers of the European recovery. However with zero GDP growth in the Eurozone in 2Q14 and Italy back in technical recession, much of the “hot money” seems to have given up hope and returned home.  We ask whether Europe is indeed doomed to years of no growth and Japanese style deflation or if alternatively it actually offers an attractive opportunity for investors.

The fact that Eurozone real GDP remains below its 2007  pre-crisis peak is a worry, and policy makers have been trying to tread the narrow path between being fiscally responsible in order to fix the budget deficits, yet trying to avoid strangling these first green shoots of recovery.  The debate over austerity versus growth has been raging over the past six years with different economies choosing (or being forced) to take different paths, often with little consistency.     

Eurozone economies were hindered early on in the financial crisis by the slow response of the ECB, actually raising the repo rate in the summer of 2008, then being far slower than their US and UK counterparts to ease thereafter.   A look at the unemployment rate across the world shows how the inflexible labour markets in the Eurozone prevented greater job losses early in the crisis (see graph), only to hinder the recovery later on.  It is particularly concerning how, whilst unemployment has fallen sharply elsewhere in the world, it has continued to trend upwards in the Eurozone.

Unemployment rate (%)

unemployment rate in various countries

Source: TT International/Bloomberg

At the corporate level, although many companies have been pro-active in restructuring and rationalising to cope with a tougher macro-economic environment, earnings in aggregate have stalled, with Eurozone earnings per share remaining at 2009 levels whilst other regions are at or even above the pre-crisis peak.

Euro area EPS are at 2009 levels

Euro area EPS are at 2009 levels

Source: Credit Suisse

Indeed, earnings forecasts have consistently been revised down by analysts each year over 2011 – 13, ultimately ending those years with negative growth.

Change in Eurozone EPS growth projections during the year

Change in Eurozone EPS growth projections during the year

Source: IBES

But this cloud may have a silver lining…

The bad news on the economy and corporate earnings is well known and came to a head recently with the shock publication of the 2Q14 GDP data showing no growth in the Eurozone.  Equity markets fell sharply in late July as many gave up hope, with US investors notable in the stampede to the exit – see chart below.

Net US buying of European equities ($m)

Net US buying of European equities ($m)

Source: Credit Suisse

That substantial “hot money” has gone is helpful to prospects from here, as remaining investors should behave in a more rational and considered manner.  Stalling economic growth is no longer “new news” so share prices would be expected to have incorporated this.

From an economic perspective there is also hope that 2Q14 may represent the nadir for a number of reasons.  First is the possibility that the 2.1% weather related fall in GDP in the US in 1Q14 had a knock-on effect to European demand a quarter later.  Driven both by economics and a recent easing of the political will for more austerity, we expect to see fiscal drag improve for many countries.  Spain, in particular, is seeing 1.9% less fiscal constraint in 2014 than it did last year.   Whilst we hear substantial press commentary about the peripheral fiscal deficits, investors should be reminded that the Eurozone in aggregate runs a primary fiscal surplus.

Expected change in fiscal drag in 2014 vs 2013

Expected change in fiscal drag in 2014 vs 2013

Source: J.P. Morgan

Hot on investors’ lips in Europe at the moment is the impending Asset Quality Review (AQR).  This is designed to be the acid test for the capital adequacy of European banks and, it is hoped, will provide final reassurance for investors that banks have sufficiently rebuilt their capital following the impact of the crisis.  In order to be credible, the test is likely to highlight a few casualties in need of further financing.  In our view these will be few and in many cases unlisted regional names.

It is estimated that, since the last stress test, €110bn of capital has already been raised or accumulated by European banks, so clearing this final AQR hurdle may indeed be a positive catalyst both for sentiment and also actively to encourage banks to lend again, rather than hoard capital.  The focus for banks has been to build capital in the run up to this watershed, so paradoxically the AQR may have exacerbated the slowdown in lending in recent months.  Once the test is complete, on the other hand, economies may therefore benefit from a catch up in lending activity.

Perhaps also galvanised into action by the recent poor economic data, Mr Draghi appeared to steal the show at the annual central bankers’ symposium at Jackson Hole this summer.  There he re-iterated the launch of the Targeted Long Term Refinancing Operation (TLTRO) in September and highlighted that preparations are well under way for outright purchases of asset backed securities (ABS).  He also suggested that the ECB would be willing to expand its balance sheet back to the peak of 2012, implying a 50% (or €1 trillion) boost – see chart.  The time period over which this takes place and the precise mechanics are unclear, but the magnitude and willingness to deliver would appear to be substantial. This ECB style of Quantitative Easing is likely to look rather different to that just coming to an end in the US.  It is unlikely - at least for now - to buy sovereign bonds, but instead be more precisely targeted to help small and medium sized companies to borrow and invest for growth, and by doing so the goal is to provide renewed impetus to the sluggish domestic economies.

Fed and ECB balance sheets

Fed and ECB balance sheets

Source: TT International/Bloomberg

Crucial to this plan is to engineer a weaker Euro, and history elsewhere suggests that QE should be successful at achieving this.  Certainly as German 10 year bond yields have fallen to below 1% (and 2 and 3 year maturities have seen their yields turn negative!) the spread with US Treasuries has widened (see chart) so investors are encouraged to sell their Euros in favour of Dollar assets.

US 10-year versus German 10-year

US 10-year versus German 10-year

Source: TT International/Bloomberg

In the short term, it would appear that the long slide in Eurozone earnings expectations may at last be coming to an end.  The Euro has recently begun a sharp fall, retracing approximately 7.5% against the Dollar since May.  A 10% move in the Euro on a trade weighted basis adds approximately 7% to corporate profitability, so even in this quarter’s earnings, the exchange rate would be expected to have a positive effect.  Even after this sharp recent fall, it would seem likely that the currency’s trend remains negative as interest rates and growth rates relative to the rest of the world point to further weakness.  This is almost certainly “encouraged” by the ECB with policy and perhaps even intervention.

$ per €

$ per €

Source: TT International/Bloomberg

At the time of writing, weekly Eurozone earnings have just been upgraded in aggregate for the first time since April 2012 – see below.  We expect this trend to continue to be positive and will, at long last, provide an earnings tailwind for European equities.

European earnings revisions

European earnings revisions

Source: TT International/Bloomberg

Whilst aggressive policy easing combined with a weak Euro would seem to provide short term support for European equities, what does the long term hold?  This depends upon the willingness to reform and restructure at both the national and corporate level.  The financial press would lead the reader to believe that nothing is happening in this regard but we would disagree.  Recent research visits by our team to Iberia give us the impression that both Spain and Portugal have indeed grasped the nettle of reform.  Ireland, of course, have achieved a remarkable feat rescuing its economy from IMF control during the worst of the crisis, to now having a current account surplus and in 2015 a budget deficit likely to be less than 3% of GDP.  Even in France, the recent narrow escape in a vote of no confidence with Prime Minister Valls, and with President Hollande’s personal rating at a paltry 13%, the administration would be well advised to progress faster down the track of reform.     

European equities have underperformed their US counterparts by approximately 80% in US Dollar terms over the past 5 years.  This is unsurprising if one compares corporate return on equity below.  Balance sheet restructuring and margin rebuilding simply have not taken place in Europe as they have in the US for example.

Return on equity

Return on equity

Source: TT International/Bloomberg

Whilst US equities have substantially outperformed Europe since the crisis, their valuation premium has narrowed versus Europe as earnings growth has also been superior.

Expected PE multiple

Expected PE multiple

Source: TT International/Bloomberg

With interest rates in many Eurozone economies at their lowest level in history, the Central Bank pumping vast amounts of liquidity into their economies, protracted weakness in the Euro, and a recovering world export market, there is a strong case for European margins to substantially narrow the gap with their US counterparts.  In this regard it is entirely feasible that European equity earnings growth outpaces that in the US over the coming years providing an attractive backdrop and a great temptation for the “hot” money to return to benefit from the long awaited European recovery.


Important Information:

Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).

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