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Question of the Week - November 3, 2014

Question of the Week - November 3, 2014

Guest Post - Monday, November 03, 2014

Is there any hope for Europe?

Several things have happened in Europe over the past few weeks that investors have been keeping tabs on.

The ECB began bond purchases recently, going through a rotation by country (e.g., Spain one day, France the next) in attempts to provide rifle-shot stimulus. However, expectations are increasingly growing that this will morph into a full-blown quantitative easing program, similar to what the U.S. and Japan have already conducted (which Japan is also expanding). Naturally, there has been some sporadic positive sentiment in response to it doing something as opposed to doing nothing. At the same time, as we have seen in the U.S. perhaps, loose monetary policy may only help to a certain degree, as the old ‘pushing on a string’ reference is applicable (a nod to a theory from noted economist John Maynard Keynes referring to the liquidity trap point when lowering rates to very low levels doesn’t really help a lot more at the margins and why QE was done in the first place). Whether they can conduct enough bond buying to matter and do it quickly enough to provide helpful stimulus remains an unanswered question.

Secondly, an ECB bank stress test was conducted as an attempt to inspire confidence in the financial system prior to a new combined supervisory mechanism run by the central bank as the first stage of a banking union agreed upon two years ago. In the test of 130 key European banks (representing >80% of ECB assets) the majority passed, but 25 did not, so about an 80% success rate. (Although there were criticisms that testing was done on year-end 2013 data, and many banks have shored things up since in anticipation of this test.) About half of the failing institutions will need to raise capital and improve their balance sheets to buffer against possible credit losses—Italy and Greece appeared to be among the worst performers. There are always complicating factors behind who passes and who fails, most of which had to do with balance sheet classifications of what are ‘assets,’ the value of loan collateral, types and number of ‘nonperforming’ loans and timing of loan write-offs (about a quarter of European banks were more lenient than the central bank was, which created an obvious problem). Such assumptions from bank to bank can dramatically alter key capital ratios. All-in-all, an expected and lackluster outcome, although some argue the test was a bit weak and only measured the largest banks, ignoring weaker firms that could have more severe hidden problems, and disregarded possible impacts of a deflationary environment. Perhaps a bigger issue is, as the banks are deleveraging from the last crisis, private sector new loan creation is poor, which is hampering efforts to grow out of the current recession—all despite ECB support of low rates. More work will need to be done in the financial sector for sure. After taking over regulatory authority, the next step for the ECB is the creation of a bank resolution fund in 2016, which may be even more complicated on several levels—not to mention reaching agreements on the political side.

While the Eurozone is similar to the U.S. in many ways, sharing a Western view of the world, rule of law and similar-sized combined economy and population, it has a variety of differences, all of which play into how quickly and efficiently it will be able to crawl its way out of this current predicament. Europeans, particularly Germans, have a very paranoiac view of inflation—considering the rampant hyperinflation of the Weimar Republic in the 1920’s with not-so-fond memories of worthless paper currency being rolled about in wheelbarrows, this isn’t surprising. (The reasons for this weren’t from a QE episode, but from post-World War I reparation bills, but that’s a longer story.) Just as the Great Depression did in the U.S., such experiences leave a deep imprint on a nation’s psyche and worldview for generations to come. The last thing the Germans want to have is a repeat, as unlikely as such an outcome might seem from our modern point of view. Of course, it’s hard to imagine at this point with inflation so low (0.3%) that deflation seems more of a worry, but this is a psychological and cultural barrier to over-stimulating things.

Labor markets in Europe are also more rigid than in the U.S. While Americans have moved steadily away from labor unions since their peak in the mid-20th century, Europe suffers from more embedded socialist structures that are intertwined with organized labor interests—this makes it much more difficult to quickly adjust the work force to match changing economic conditions and, thus, keeps fixed costs consistently higher. France often comes to mind when analysts discuss these rigidities. While no one likes layoffs, the American model is a free-market function that helps firms remain competitive and match the number and types of jobs needed to the jobs offered. Arguably, Europe tends to value a more egalitarian ‘quality of life’ more than we do (and has a history of proletariat conflict versus the ruling classes), while we see ourselves as a nation of upwardly mobile employees and small-business owners. While some of the differences may be nuanced, they do get to the heart of where these policies originated.

Lastly, of course, there are inherent differences between the Eurozone’s northern ‘core’ and southern ‘peripheral’ countries. The northern nations, including Germany, France and the Netherlands are seen as the stoic ‘rust belt’ manufacturing powerhouses with better fiscal discipline; whereas the southern neighbors of Spain, Italy, Greece and Portugal, are seen as less industrialized, less organized and fiscally less responsible. Last week, we spoke about why currencies gain or lose strength, and, pre-Euro, it tended to be the safe haven/strong German mark pitted against the more volatile Italian lira, Greek drachma, etc. The persistent strength of the German currency was a headwind in exports to southern Europe. So, one Euro currency benefitted everyone—especially Germany—as the Euro evened the playing field through an implied currency devaluation. For the southern countries, it provided implied currency strength. For the early part of the 2000s, the entire union benefitted, but now, the bill has come due. The ECB is now in the position of pressing the stimulus button and pushing the Euro currency’s value down further, to strengthen its global competitiveness. Running a budget surplus and being the largest member, Germany is in the position to control the purse strings.

At the end of all this, investment markets care about growth (equities) and loan principal being paid back (bonds), so those become the points most focused on. Growth may be slow for a while, and this impacts not only European companies with domestic customers but also foreign firms (such as companies in the S&P) that garner a fair amount of earnings from abroad. This may not get worse, necessarily, but may take time to improve. Then again, this is why valuations can become discounted, and markets don’t wait for improvement—they tend to act in advance. As long as the ECB is acting as a backstop for sovereign debt and is serving to depress interest rates in general, credit risk may remain contained. Unfortunately, rates are so low that conventional European debt isn’t that attractive (e.g., 10-year German bund rates at 0.85%). Europe has a multitude of world-class multinational companies (as does the U.S.), with a global customer and revenue base, so, at times, the domicile of where a company is headquartered is becoming increasingly irrelevant in today’s world.

There has been a back-and-forth in regard to the impact of foreign weakness versus U.S. strength; namely, how European disinflation could translate back into lower U.S. earnings. This doesn’t seem to be a major impact yet, but these do take time to filter in (as in a quarter or two). For European equities, a weaker Euro could help matters—particularly in export-heavy regions like Germany.

Expectations for 2014 remain low. However, estimates for European GDP growth in 2015-2016 improve to the 1.0-1.5% range, with inflation getting back up towards and above 1.0%. It’s important to keep some perspective. There is some fine-tuning to be done, especially with a cohesive multi-nation financial system, but with a population and level of wealth similar to that of the U.S., consumers will continue to spend, and business will be forced to continue to plod along as opposed to falling off the grid. Equity valuations in general are a bit below average, but, even more importantly, this may be a period where active management is especially important in separating companies with more direct exposures from more solid firms with a more diversified global footprint, yet domiciled in Europe and excessively punished by headlines.

Additional Reading

Read our Weekly Review for November 3, 2014.

Read the previous Question of the Week for October 20, 2014.

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