By Henry McVey, Aidan T. Corcoran Apr 09, 2015
Aidan Corcoran, who covers European macroeconomics for KKR, and I recently spent some time in London and Madrid on the way to the KKR European PE conference. Our Thoughts from the Road are as follows:
- Europe remains on an economic upswing, and as such, we are now revising our 2015 European GDP forecast to 1.7% from 1.3%, against current consensus of 1.3% (Exhibit 6). We see multiple ways for growth to “win” in Europe in 2015, including low rates, cheaper oil, less fiscal drag, and a weaker euro. See Exhibits 7 and 8 for details, but our quantitative GDP model is even more bullish, suggesting 2.4% growth over the next 12 months.
- Mario Draghi, who we view as one of Europe’s most skilled “politicians,” has orchestrated a perfect time to launch Quantitative Easing (QE), in our view. Using negative inflation prints as his call-to-arms, Mr. Draghi has implemented an outsized QE program relative to the existing base of available sovereign supply in Europe – one that also has a surprisingly low bar for continuation in 2016. Importantly, if we are right that GDP growth is poised to reaccelerate by summer 2015, then his recent decision in January to forcefully get QE across the goal line at a time of great economic uncertainty/fear of deflation will be remembered as being extremely well timed (i.e., bullish for both growth and risk assets).
- In terms of credit conditions, the gap between some of the Haves and the Have-Nots has narrowed. In particular, Spain’s bank lending rates for small-to-medium-size businesses now look more like France and Germany1. By comparison, Italy’s lending rates in this area still look artificially high. Overall, though, we again left the Continent with ample evidence that European SMEs still do not have adequate access to the credit they need to grow.
- We spent some time listening to a few experts talk about European capital market structure. We left unimpressed. While banking union has become a reality, capital markets union remains only an aspiration. If there is good news, ongoing opaqueness would seem to favor patient capital that can take advantage of arbitrary pricing and/or harness volatility to its advantage.
- Our due diligence on the Spanish economy again reinforced our long-held bullish stance, and we left wondering whether Spain could grow faster in GDP terms than the United States in 2015. Exports are humming, consumption is better than expected, and housing has bottomed2. If there is a textbook example of our European marginal macro momentum thesis, then Spain is it.
- Some of the well-informed macro and economic folks with whom we spoke view China’s slowing as more of a risk than Greece. We tend to agree. In particular, we note that China’s debt to GDP is nearly 250% (including State Owned Enterprises and Local Government Vehicle debt) versus 170% for the Greek public sector. Moreover, it now takes at least 10 units of debt in China to drive one unit of GDP versus just three units back in 20073. To be sure, Greece certainly has its issues, but the problem is potentially more contained. Consider today that just 15% of Greece’s total sovereign debt outstanding is held by foreign private investors, compared to 70% in 20094.
- Social unrest and political tension remain risks to the story. Across Europe we think that wage growth is likely to remain sluggish, while liberal benefit packages, including pensions, may continue to be slimmed down. Against this backdrop, investors must prepare for internal discord, which could affect risk premiums, particularly in Spain and France. Also, Scottish secession is now a real risk in the United Kingdom.
We Believe the European Economy Has Repositioned Itself for Some Return to Normality
Overall, we left Europe bullish on growth, and we still see more upside for risk assets. As such, we continue to advocate our Marginal Macro Momentum thesis of focusing on sectors and countries where the macro momentum has turned positive. However, the bigger picture conclusion we left with is that we believe European GDP is ‘Returning to Normality’ after several years of austerity, bank de-leveraging, and current account narrowing.
Europe Has Handily Outperformed the U.S. Year-to-Date
Against this more favorable macro backdrop, the Eurostoxx has already outperformed the S&P 500 by over 1700 basis points (Exhibit 2). However, we think there could still be more upside into 2016. Key to our thinking is that — with 65% of European stocks still trading with dividend yields above their bond yields – Europe is now in a valuation position similar to the United States in 2011 before the SPX’s valuation spiked higher5. True, PE valuations on the surface look rich in several parts of the market, but we think both margins and earnings are under-stated in hindsight, particularly if our macro view on the euro, oil, and rates is right.
The bigger question that long-term PE-type investors in Europe are now left to ponder is not 2015; the economic environment is now largely pre-determined, we believe. Rather, it is the long-term. In particular, we wonder whether the current bullish macro tailwinds are actually too favorable to usher some of the more structural changes that Europe needs to offset poor demographics and labor rigidity, particularly in countries like France and Italy. Together those two countries account for 37% of Eurozone GDP and they are doing very little to keep up with some of their more economically flexible peers, including Germany, Ireland, and Spain 6.
In the near-term, we believe these nagging structural concerns likely will not matter, but they will make a difference down the road as the global economic cycle reaches full maturity around 2017/2018. And if indeed Europe is a union, then during periods of crisis and difficulty, it is usually only as strong as its weakest link.
GDP Forecast Up: Multiple Tailwinds Are Broad-Based. As folks know, the key to any major credible debt reduction story is getting nominal GDP above nominal interest rates, so that economic growth can chip away at a country’s outstanding stock of debt. Without question, Europe’s decision in 2011 to embrace austerity made this outcome quite difficult to achieve, in our view (Exhibit 3).
Today, however, this is no longer the case. After the European ‘Authorities’ backed off on their fiscal belt-tightening in 2013-2014, the situation has improved dramatically (Exhibit 4). Indeed, growth is now humming along at a respectable level for the current asynchronous global recovery, and as one can see below, nominal GDP is now finally high enough to reduce debt loads, create some job gains, and bolster consumer sentiment.
Back in 2011, Few Countries Had Enough Growth to Chip Away at Their Sizeable Debt Loads
By Comparison, 2015E Forecasts Shows the Meaningful Improvement in Both the Core and Periphery
What we find even more encouraging is that Europe now has multiple macro levers to help boost growth. For starters, we note that the fiscal drag from 2013 to 2015 is falling to around zero from 70 basis points in 20137. This pullback in fiscal austerity cannot be understated, as the negative multiplier effect on GDP had ballooned to 1.5x versus a historical average of around 0.5x. Second, the euro is now down over 21% from a peak of 1.40 in May 2014. Estimates vary, but most folks believe that a 10% decline on a trade-weighted basis is the equivalent of a 50 basis point boost to GDP in about four quarters time. Third, lower oil prices are a boon to both GDP growth and private consumption. All told, my colleague Aidan Corcoran believes that each 10% decline in oil prices adds 20 basis points to GDP after about 12-24 months (Exhibit 5). So with oil now down 50% from the June 2014 peak in euro terms, this tailwind is quite meaningful. Finally, with 10-year German bund rates hovering at 30 basis points, financial conditions at least in the mainstream parts of the economy are extremely compelling relative to history8.
Against this backdrop, we feel comfortable raising our 2015 GDP forecasts to 1.7% from 1.3% (Exhibit 6), and there is still a good chance that we could need to boost our growth forecast further. To get a feel for this upside risk, we updated our quantitative model (Exhibits 7 and 8). As the charts indicate, a purely quantitative assessment of a lower euro, a positive oil shock, and lower rates all suggest something north of 2.0% growth. Moreover, the model is still suggesting that weak housing activity/pricing will hurt growth, but recent data suggest housing is turning more positive in almost all of the countries we have visited across the Eurozone during the past 6-12 months (Exhibit 8).
The Impact of Changes in Oil Price and Euro Weakening on Eurozone GDP Are Significant Even Before One Includes the Benefit of QE
We Remain Committed to Our View That This Recovery Remains Asynchronous, Including Lower Than Expected Inflation in 1H15
Our Quantitative Model Suggests Our 1.7% Fundamental GDP Forecast is Too Conservative…
…And Sees Growth Accelerating at a More Rapid Pace
QE: Timing Is Everything. When Aidan and I last traveled through Europe in 4Q14, deflation concerns were all the rage among business leaders, investors, and government officials with whom we spoke. In hindsight, the collective view of these folks was prescient as inflation trends have taken a nasty turn down into negative territory in recent months. However, the situation has improved on two fronts. First, labor has been pushing back, demanding higher wages in important markets like Germany in recent months. Second, Mario Draghi’s implementation of an outsized QE program now appears extremely well-timed for arresting both near- and long-term deflation concerns. One can see the magnitude of the deflation overhang in Exhibits 9 and 10.
Recent Inflation Trends Are Well Below the ECB Target of 2%
Long-Term Inflation Expectations Also Remain Extremely Subdued
Potentially more important, we think, is that Draghi has set a surprisingly high hurdle to stopping QE in 2016. Specifically, he has indicated that he will continue to use QE as a tool unless GDP growth is hitting 1.8% and inflation is 1.5% or higher. Importantly this outlook is notably above that of the average European economist, who sees growth at just 1.6% and inflation at 1.2%. Put another way, QE needs to be hugely stimulative, or Draghi is likely to maintain the current program – and potentially do even more.
The ECB Is Purchasing €60 Billion Per Month…
…Which Will Grow the Balance Sheet by 50% by September 2016
Eurozone Purchases Come at a Time of Low Government Debt Issuance, Which Will Boost Prices and Cause Migration to Riskier Assets
Already, a Full 25% of Eurozone Government Bonds Have a Yield of Less Than Zero
The knock-on effect on the currency from the bond buying program must also be considered. Simply stated, domestic institutional holders (e.g., insurance companies and pension funds) in Europe literally need to hold the bonds to comply with certain regulations and minimums. As such, ongoing ECB purchases may force foreign investors to further lighten up their European sovereign positions. We believe if this scenario does play out, it will further weaken the euro as they sell, which will give additional stimulus to the European export outlook.
Our bottom line on European QE: After studying QE in the U.S. and Japan, we are still not convinced that it sustains long-term economic growth. However, we do know it drives yields lower (Exhibit 15), and we do know that timing QE to boost confidence can affect GDP growth. And in terms of timing and delivery, Draghi gets extremely high marks.
Bond Yields are Negative to at Least the 3-Year Point of the Curve in Several Major European Countries
Capital Markets Convergence: More to Be Done. In addition to our macro meetings, Aidan and I spent some time at a conference on the future of European capital markets structure. Our key takeaway was that the banking union is not likely to lead to a capital markets union anytime soon, particularly as it seems the major near-term focus is to further constrain traditional financial intermediaries (Exhibits 16 and 17). Also, while the European high yield market is catching up with the U.S. market in terms of issuance and activity, there is still a long way to go to serve medium-size businesses across Europe9. Just consider that the U.S. capital markets are still 5x the size of European capital markets when it comes to servicing mid-size companies with the credit they need, according to the investment bank Morgan Stanley.
It Will Be Hard to Implement Capital Markets Convergence When Capital Markets Activity Is Being Curtailed
European Banks to Shrink Their Total Balance Sheet Size Around 15% by 2017
In terms of why convergence towards an integrated bond market that should replace the traditional lending schemes that dominate Europe makes sense, we can think of several reasons. For starters, it would allow for longer-term, more permanent funding than loans. Two, it would attract more global capital. Third, as we have seen in the United States, it would inspire more innovation. Finally, it creates a more stable and diverse financial services backdrop as risks are dispersed, not concentrated among a few levered institutions (many of which are national champions).
In terms of catalysts for change, we think that at least three things need to happen. First, Europe needs some more demand pull, which means government focus on self-funded retirement accounts versus traditional pension schemes. Second, Europe needs better bankruptcy laws, and third, there has to be greater agreement across jurisdictions.
In the near-term, we see very little changing, which we think means Europe will have a higher cost of capital – all else equal – than other developed markets. If there is good news for investors, we think it could be that this ongoing backdrop of capital markets inefficiencies should mean 1) the illiquidity premium likely stays higher for longer; and 2) more complex transactions are increasingly ceded by the banking community to a variety of alternative asset managers, many of which can provide financing solutions across a corporation’s capital structure.
But over time, Europe needs to do more to catch-up with its peers around the globe. Innovation is attracting capital, and one needs to look no further than the Hong Kong-Shanghai “Through Train” to see that marginal capital will follow the path of least resistance. To this end, we believe the European Authorities need do more over the next few years to become more competitive.
Why Has the Spanish Experience Been Different? We see three elements of why Spain has been one of Europe’s bright lights in recent years. First, it addressed labor force rigidity earlier and more forcefully than its peers. One can see this in Exhibit 18, which shows a massive decline in wages at a time when many countries in both EM and DM regions experienced 5-10% annual wage gains10.
The Adjustment in Labor Costs Is Well Advanced in Spain
Without question, this initiative improved competitiveness, exports in particular. All told, exports as a percentage weight in GDP were 32% in 2014, up from 25% in 2008 (Exhibit 24). Interestingly, we continue to hear of companies, particularly in areas like autos, which have relocated from France to Spain in recent quarters. At the risk of stating the obvious for those who visit Spain, we believe that the infrastructure, including rail, road, and plane are on par with some of the most advanced Asian cities that we visit. Engineering and tourism have also been major beneficiaries. On the latter, we note that foreign visitors are growing by 7% year-over-year (Exhibit 23).
Second, the government immediately began to address its banking sector woes when it recapped many of its banks starting in summer 2012. All told, the capital raised for the sector has reached north of 35% of GDP, on par with Ireland’s injection of 40% of GDP and compared to 11% or so for the U.S. following the financial crisis. Moreover, the government has worked hand in hand with the private sector to set up a bad bank, recapitalize its viable banks, and encourage consolidation in the sector, so that the financial plumbing could recover faster than the country’s peers.
Third, Spain is now enjoying easy comparisons that are not available in a country like France, which has such a large government sector that the variability of annual economic output remains somewhat muted across a variety of global macroeconomic environments. So, while it is true that Spanish car sales are up 20% year-over-year in 2015,11 what sometimes get lost in the message is that car registrations peaked at 173,000, fell to a low of 35,000, and are now back to just 87,000 (Exhibit 20). A similar story holds true in construction, particularly on the residential side. As such, we believe any mean reversion in key cyclical sectors could likely mean significant upside in terms of volumes, etc.
Less Government Has Led to More Labor Flexibility and Growth in Spain
Given the Magnitude of the Decline in Several Cyclical Areas, The Upside Still Remains Significant
Overall though, we believe Spain made a concerted effort to “right” itself in 2011, its GDP growth is now in line with the U.S. at roughly 2.0-3.0% and well above many of its European peers. Embedded in this estimate is our belief that consumption growth is faster than GDP, compliments of lower gas prices, declining unemployment, and recent tax cuts (the equivalent of a 12% year-over-year decline). On the export side, most macro folks see exports growing 4-6% this year (with 72% of exports going to Europe), and they expect housing to finally have a positive impact on the economy, versus its prior role of being a major drag. Specifically, residential construction could grow 5.1% in 2015 (and as high as 10% in 2016) versus -1.8% in 2014.
Looking at the big picture, we think that Spain remains one of the most dynamic opportunities in the Eurozone. We believe the country has an incredible infrastructure system, which is appealing to foreign companies and boosts export competitiveness. These tailwinds are in turn creating stronger consumption, which is being further aided by lower taxes and less fiscal restraint. Potentially more important though, is that it is reflective of a European story is that may still be somewhat under-appreciated by global investors, many of whom may not have fully digested the significant benefits that are accruing after a 50% price decline in oil, a sharply lower euro, and record low financing rates.
Risks to the European Story Remain. No doubt, things feel pretty good in Europe these days, but we still see several risks that we are watching closely. The first is Greece. While our base case is that Greece will find a path to a third bailout that does not involve a euro exit, the risks remain serious. In particular, capital controls are not out of the question over the next four to six weeks, and in terms of ensuring the euro is irrevocable, the Troika needs to make sure not to push Greece out of the Eurozone.
A second key risk we see is complacency. This risk applies both at the market level, where valuations have gapped up since the start of the year (Exhibit 2), and also at the household level, where consumers are reacting to the benefit of higher asset prices a little faster than we anticipated. One can see this in Exhibits 21 and 22, which suggest consumers are discounting continued weakness in oil and the euro. Indeed, our trip to Spain revealed that consumption could grow 2.5% in 2015, suggesting that few locals are using the recent economic improvement to repair their balance sheets.
Consumer Confidence Is Improving Across Europe…
…As Evidenced by Major Purchase Intentions
Third is politics. While we think that the current Greece saga has made radical left-wing movements less appealing in Europe, there is no denying that the lack of wage growth for the average European is leaving many feeling that their government has broken the social contract on economic prosperity. In particular, we heard a lot about situations where workers were returning at half the wages they garnered just 24-36 months ago.
Without question, we believe weak wages and high unemployment could lead to social and political unrest if the situation does not improve materially by 2016. These weighty social and political issues are certainly top of mind in Spain, and looking ahead, one could expect further unrest in the U.K. as it enters its upcoming election cycle.
Conclusion: Returning to Normality. After having traveled to China and Brazil in recent months, my European tour was actually somewhat refreshing from an economic perspective. Growth is rebounding, expectations are still low, and the liquidity backdrop is plentiful. Against this outlook, we think high dividend public equities will outperform. High yield, though not really high in yield, should remain well bid.
The Global Economic Recovery Will Aid the Tourism Industry
Exports as a Percentage of GDP in Spain Are on the Upswing
On the private side, we still see the trade-down theme as viable, given punk wage growth. Exports, real estate, and certain cyclical industries, including construction and autos, should get better. However, we expect existing corporations to potentially drive the next leg up in PE investing, as the more favorable economic backdrop should now give them some breathing room to reposition their portfolios.
Finally, the banking system in Europe is still in repair, which is constructive for alternative asset managers. However, given the ECB’s accommodative stance (and its strong desire for banks to lend), we left Europe believing that traditional financial intermediaries are going to be much more aggressive than in the past in trying to get capital out to borrowers. To be sure, many banks in Europe still need to fix their existing book of business, but our conversations left us more cautious about non-traditional lending than in the past.
1 Data as at January 31, 2015. Source: Macrobond.
3 Data as at December 31, 2014. Source: China Customs, Haver Analytics.
4 Data as at December 31, 2014. Source: Bloomberg, BoG, EC, IMF, PDMA, UniCredit Research, Barclays Capital.
5 Data as at October 21, 2014. Source: Datastream, Goldman Sachs Global Investment Research Adventures in Wonderland.
6 Data as at December 31, 2014. Source: ECB, Haver Analytics.
7 Data as at December 31, 2014. Source: OECD Economic Outlook 96 Database.
8 Data as at March 18, 2015. Source: Bloomberg.
9 Data as at March 25, 2015. Source: JPM Research.
10 Data as at December 31, 2014. Source: OECD, Haver Analytics.
11 Data as at February 28, 2015. Source: Anfac.
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