By HENRY MCVEY Oct 24, 2013
As we first detailed in our May 2013 piece “Europe: Focus on the Marginal Change,” our base view remains that the current restructuring in Europe has many similarities to other post-crisis recovery stories, including Asia after it faltered in the late 1990s. Like many debtor nations before them, European countries are being forced to restructure their economies to include more competitive exports, fewer imports and less government outlays. Importantly, in doing so, we believe it is creating significant opportunities for investors who are keen to focus on where the marginal macro momentum has begun to turn more positive during Europe’s initial recovery phase. No doubt, not every sector or country will enjoy prosperity, but our latest research, including several on the ground visits to the region, again lead us to believe that our marginal change thesis remains on target.
Without question, “divining the future” is a difficult task, particularly in a profession as complex as the investment business. But as we have learned over time – unfortunately the hard way in many instances – “studying the past” can help investment professionals think more clearly about how economic and capital markets trends might unfold in the future.
At the moment, we think one of the best macro opportunities for “divining the future by studying the past” centers on Europe, which has been hit hard by too much debt and too many imports in recent years. Indeed, as we first detailed in our May 2013 piece Europe: Focus on the Marginal Change, our base view remains that the current European restructuring has many similarities to other post-crisis recovery stories, including Asia after it faltered in the late 1990s. Like many debtor nations before it, European nations are being forced to restructure their economies to include more competitive exports, fewer imports and less government outlays. Importantly, in doing so, it is creating significant opportunities for investors who are keen to focus on where the marginal macro momentum has begun to turn more positive during this initial recovery phase.
No doubt Europe is no Asia; its demographics are less favorable, its fiscal treaties are more cumbersome and its unemployment rates are outsized. Also, Asian countries devalued their currencies by 57% on average following their regional crisis, versus a four percent increase for the euro over the past 12 months (Exhibit 18). But even with its many challenges, each additional trip to the region we have made of late increasingly leads us to believe that Europe’s restructuring initiatives are creating some notable investment opportunities at a time when sentiment on the region is still lukewarm at best. Moreover, European growth in 2014 could be better than many folks now think as austerity initiatives in the region are subsiding at the same time global growth appears poised to re-accelerate.
So given that we have been back to Europe several times since we began “studying the past” to learn more about potential investment similarities, we thought it might make sense to detail some of our latest thoughts on the region. They are as follows:
- “Focus on Marginal Change” Thesis Still On Target… Given the substantial wealth destruction that took place in Europe relative to other parts of the world over the past few years (e.g., Europe has underperformed the U.S. by nearly 50% since 2007), our view remains that there are now significant opportunities for investors who focus on where marginal macro momentum is improving in this beaten-down region (Exhibit 15). We believe restructurings in the auto sector, lower labor costs in the export sector and further reinvestment in energy-related areas are all examples of initiatives that recently helped to turn GDP positive after six consecutive negative growth quarters (Exhibit 13). So we are expecting – at a minimum – a substantial “catch-up” investment period in many parts of the European equity and credit markets at this point in the region’s economic cycle.
- …But There Is Still More Europe Needs to Do More to Get on Par With Its Global Peers. See below for details, but we believe lower labor costs alone may not be enough for Europe to become globally competitive on a sustainable basis. Simply stated, in our view, the region needs to do more to lower its input prices, including energy and electricity prices. It also should boost productivity in both the public and private sectors. Separately, we remain convinced that the European Central Bank (ECB) should think more about the low level of inflation that now exists – and what it means for nominal revenue growth, particularly when the Union’s currency, the euro remains stubbornly strong. Finally, we believe European governments are not only too big a component of overall GDP, but also the productivity associated with their current expenditures is subpar.
- A Playbook for the Periphery. For some time we have been an advocate of focusing on export stories in countries like Spain, Ireland and Portugal. Through improved labor competiveness, many exporters in these countries have seen notable upticks in their business prospects. However, the export story is more consensus now than it was six or 12 months ago, so more selectivity may be warranted. Meanwhile, each country appears to be recovering at a different economic pace, leading to different investment considerations in the various countries across the region. So to better understand how an investor should approach each country, we have developed somewhat of a macro “playbook” for thinking about the value chain in places like Spain, Portugal, Ireland, etc. Details below.
- The ECB and BoE Are Becoming More Targeted in Their Approach to Monetary Policy. Following the Fed’s lead of targeting housing via mortgage purchases, European central banks and other government officials appear more focused on specific plans to revive cyclical growth parts of the economy. Without question, we view this transition in monetary policy from a blunt knife towards more of a sharp scalpel as an important positive development. As we detail below, a rebound in important cyclical sectors, including autos and housing, would be required if growth is ever going to return towards trend potential.
- Congested Credit Channels Remain a Headwind for Growth – But an Opportunity for Investors. Despite having a banking system that is three times the size of its GDP, credit channels in Europe are still clogged.1 There is also the adverse trend towards cross-border capital repatriation. Without question, we believe these dislocations across the funding markets are impeding growth. But they are also creating a tremendous opportunity for providers of capital, particularly those with longer time horizons and the ability to underwrite difficult credits. As we head into 2014, we think the ECB’s new role as supervisory director of the banking system could serve as a further catalyst for additional asset sales, restructurings and dispositions.
Overall, our recent trips to Europe make us feel better about our exposure to the region throughout our target asset allocation framework, including both private and public exposure. On the public side, we fully acknowledge that we were early to move to neutral from underweight for European equities in this framework at the beginning of the year. It has not worked as well as we had hoped. Specifically, year-to-date through September 30, 2013, European equities have trailed the U.S. by 5.6% (Euro Stoxx 12.3% versus S&P 500 17.9%), though they have outperformed some key emerging markets by 10-20% thus far in 20132.
However, in recent weeks performance in our European allocation is now gaining momentum; in fact, since July 16, European equities have begun what we think is an important “catch-up” investment period, outperforming the U.S. by 7.8%.3 Moreover, as we look towards 2014 and beyond, we think Europe could again be an outperformer as sentiment rebounds and earnings bounce from trough levels.
On the private side in Europe, investors are now finding value in several sectors and regions. Interestingly, as Exhibits 1 and 2 demonstrate, sentiment is still negative at a time when margins and profits are below trend in many industries. Moreover, the illiquidity premium also remains outsized throughout the region, and we are now seeing more opportunities as corporates restructure, consolidate and/or divest certain business lines. As such, our view remains that we like the overall risk and reward in European private equity right now.
Fears Around Europe Remain Quite High
Eurozone ex-Financials Margins and ROE Are Now at a Substantial Discount to the U.S.
Our bigger picture thought however, is that if 2013 has taught us anything, it is that maintaining a balanced global approach to private equity and public equity currently makes the most sense. On the one hand, we appreciate concerns that the developed markets generally have too much debt and slower growth, but rule of law, significant central bank stimulus and solid corporate profitability still make these regions compelling, in our view. On the other hand, strong growth in emerging markets is being offset by poor macro policies, social tension and higher than expected inflation and currency volatility in many instances. So in our view, it will be a balanced approach to regional equity allocations that appears likely to outperform at this point in the macroeconomic cycle.
Marginal Macro Momentum Thesis Still Intact
As we mentioned earlier, the basic investment playbook that we laid out in our May 2013 piece Europe: Focus on Marginal Change remains anchored in our belief that there are important lessons from the 1998 Asian Financial Crisis that we can apply to the current European situation to find when and where the marginal macro momentum is turning more positive. Painful restructurings, similar to what we saw in places like Thailand, Malaysia and Indonesia post-1998, may ultimately lead to sizeable gains for investors willing to step in during tumultuous periods to provide financing when margins and returns are subpar.
Similar to Asia Post Crisis, Europe Is Now Working to Trim its Current Account Deficits
Current Account Balance, % of GDP
Asian Financial Crisis Countries
Euro Financial Crisis Countries
…But Bond Spreads Still Have a Ways to Go Before Returning to Pre-Crisis Levels
Government Bond Yields
Asian Financial Crisis Countries
Euro Financial Crisis Countries
The performance of Asia after its crisis was what we view as a textbook restructuring, as the region leveraged a combination of the three Ds: currency devaluation, debt default, and labor cost deflation. As one can see in Exhibit 6, local Asian currencies depreciated 40-80% on average, and as a result, rapid wage deflation ensued. So – almost overnight – ASEAN countries became much more competitive again, which was important for reigniting growth. And within two years, external debt as a percentage of gross national income declined by 33%, to an average of 59% from 93%. By 2007, this same ratio had collapsed to just 30%.
…But Labor Costs Are Starting to Fall, While Growth is Starting to Improve
Post the Asian Crisis, Many Asian Countries Became Competitive Relatively Quickly
Exchange Rate vs. US$
External Debt % GNI
GDP per Capita (US$)
For European Union members however, currency devaluation has not occurred thus far, while debt default has been restricted to small periphery countries like Greece. As such, in aggregate Europe’s rebalancing – to date – has largely been limited to the most difficult of the three Ds: labor cost deflation. The good news is that the region has made significant progress on the competitiveness front. Indeed, as one can see in Exhibit 5, the net change in many European economies has been quite profound. For example, in recent years nearly 70% of Spain’s strong growth in exports (Exhibit 37) has come from increased demand in non-EU countries, including many low cost, fast-growing emerging markets. Pre-crisis, by comparison, this type of growth trajectory in an “old world” country like Spain would have been unthinkable, in our view.
Importantly, because labor cost deflation has helped to inspire improvements in competiveness, Europe has also been able to shift its macro imbalances towards more stable conditions in two primary ways. First, as Exhibits 7-10 illustrate, many of Europe’s fiscal and current account balances are now in much better shape after some serious belt-tightening over the past few quarters. Given that these improvements occurred during a period of lackluster global growth, our base view is that European companies, particularly its exporters, appear to have gained market share.
Many of Europe’s Fiscal Deficits Are Still Large, But…
…They Are Starting to Improve, Compliments of Belt-Tightening
A Similar Story Is True When It Comes to Current Account Balances…
…As Some of the Biggest Offenders Have Worked Hard to Reduce Their Current Account Deficits
Second, over time improvements in competitiveness throughout the private sector should ultimately have a positive influence on the overall health of the public sector. Specifically, these improvements should allow European governments to finally begin to chip away at their sizeable existing debt loads by finally boosting nominal GDP above nominal interest rates. No doubt, Europe has a long way to go before it reduces its sizeable debt loads (Exhibits 11 and 12), but recent economic momentum is encouraging. Indeed, as Exhibit 13 shows, second quarter GDP in 2013 was finally positive, and we expect further fiscal improvements in 2014 and beyond (Exhibit 14), which should be good for debt reduction initiatives.
Public Debt to GDP Is Actually Still Increasing In Europe…
…Driven by Rising Debt Levels In Spain, France, Portugal and Ireland
Gross Public Debt
% Euro Area Debt
…But European GDP Is Finally Turning Positive
…and Its Fiscal Position Is Getting “Less Bad”
Looking ahead, our base case is not that broad-based marginal macro momentum sweeps all of Europe into a fully sustainable recovery. Rather, we expect a modest overall recovery that remains below potential GDP as European countries continue to restructure and delever. While Italy still has the potential to go backwards, countries like Ireland and Spain are notably improving their fiscal positions through smaller current account deficits, rising exports and more competitive labor (Exhibits 8 and 10). So, if our playbook of “studying the past” is valid, then we think these recent initiatives in Europe may continue to drive equity valuations higher and credit spreads tighter than the consensus thinks in many instances. Moreover, given that sentiment is still poor and wealth destruction still significant (Exhibit 15), we think the potential for a catch-up trade in Europe remains a significant opportunity for investors.
If Europe Enjoys Any Form of a “Catch-Up” Trade, It Could Be Substantial
European Equity Markets Have Begun to Outperform the U.S. Equity Markets Since Mid-Summer
…But There Are Plenty of Areas Where Europe May Need to Run Faster to Remain Competitive.
While our basic investment outlook centers on our view that the recent crisis is forcing Europe to become more competitive, we fully acknowledge that more must be done to inspire long-term sustainability in competitiveness throughout the region. In particular, we see at least three structural headwinds that should be addressed for Europe to sustain faster growth amid greater global competition. First is that monetary policy seems too tight and the local currency appears too strong for a deleveraging economy, in our view. Without question, both are currently acting as important growth deterrents, particularly relative to global peers. If one does not believe us, just consider the alternative: Japan. Indeed, as part of the current Japanese deleveraging and restructuring initiatives, its central bank has helped to push the country’s currency down nearly 20% over the last 12 months through a massive increase in its monetary base (Exhibit 17). But as as the exhibit shows, it is not just Japan that is running with an extremely accommodative monetary stance: China and U.S. are both aggressively expanding their monetary bases as well.
So why does Europe have a strong currency at a time of slow growth and steep deleveraging? Our view is that by allowing its banks to repay their Long-Term Refinancing Operations (LTRO), Europe actually has been shrinking its monetary base at a time when its global peers continue to expand their bases aggressively. One can see the outcome of this policy mismatch in Exhibit 18.
The Euro Area Monetary Base Has Shrunk 27% Year-Over-Year
The Euro Likely Needs to Weaken in Order to Help Further Boost Competitiveness
Local currency appreciation amid a targeted bank and government delevering process is highly unusual relative to history. At its core, it may mean that at least some of the favorable progress on labor competiveness is being stunted. It also implies that inflation is likely to remain extremely low, which means any nominal revenue and income growth may be even harder to generate. And coupled with unfavorable demographics, our conclusion is that Europe’s current monetary and currency policies seem highly inconsistent with its stated goals of lower unemployment and faster growth.
A Shrinking Labor Force Suggests Weaker Inflation
Financial Deleveraging Is Also Deflationary
Second, as my colleague Dave McNellis highlighted to me during a recent trip, the input cost differential between Europe and the U.S. has become quite large. One can see this in Exhibit 21. The elevated price of European-benchmark Brent crude (Exhibit 22) is a critical pressure point. Another is the fact that electricity prices remain quite high in Europe compared to other regions, particularly the U.S. (Exhibit 23). The relative cheapness of natural gas in the U.S. is one key factor holding down electricity costs relative to Europe. Importantly, we expect both European oil and gas to remain comparatively expensive in coming years, as the U.S. shale technological revolution helps provide mounting captive energy supplies to North American markets.
A Significant Competitiveness Hurdle Is That European Raw Material Costs Have Increased Relative to Global Peers…
…Driven Partially by Higher Crude Oil Prices…
…And Also Boosted by Elevated Electricity Prices Relative to Global Competitors
Third, for Europe to be more globally competitive, it needs to prevent further crowding out of the private sector by the government. As Exhibit 24 shows, the role of the government is greater than 50% of total expenditure in many of Europe’s most substantial economies, including France and Italy. Not surprisingly, both of these countries have posted lackluster growth in recent years. Separately, we believe there is also the need for the public sector to allocate its sizeable annual spend more effectively.
Relative to GDP, France Has the Largest Government Sector in the Eurozone
So our bottom line is that we think Europe is slowly turning a corner in terms of competitiveness and growth, but it still will need to address some of the more structural issues it faces beyond just implementing labor cost deflation. In particular, it may need a more competitive energy policy, greater labor flexibility, and ultimately, we think a more competitive currency. Maybe more importantly though, the private sector needs the tools and flexibility to grow, while the role of government needs to shrink. And where the government does have active involvement, it may need to spend its outlays more thoughtfully. But as Exhibit 25 shows, there is not one Europe, and every country faces a different set of macro issues, including fiscal, financial, funding, and competitiveness issues. So, the key for Europe will be to embrace macro policies that positively affect change in aggregate, but also provide individual countries with enough breathing room to play to their own economic and cultural strengths.
There is No One Europe; Detailed Analysis by Country/Region Is Required
Gov. Debt %GDP
Fiscal Bal. %GDP
Gov. Spend %GDP
10yr Yld. Spd. vs. Ger (bp)
House Pxs y/y
Banks Tier 1 %
NPLs % Loans
Bank NPA Coverage
Cur. Acc’t Bal.
5yr Chg., Real Unit Labor Cost
5yr Chg., Real FX
Invest. % GDP vs. Median Since ‘00
Private Credit % GDP
5yr % Growth Working Age Population
P/E vs. Avg. Since ‘00
P/B vs. Avg. Since ‘00
E. Europe Detail
Data as at:
A Playbook for the Periphery
While I have been traveling to Brussels, London, Milan, Paris and Berlin for many years, my focus has been more concentrated on the periphery of late. Think Dublin, Lisbon and Madrid. Through these visits I have come to appreciate that there is definitely a specific playbook for understanding the lifecycle of investment opportunities in the peripheral recovering economies of Europe – and it differs materially from assessing a country like Germany or the U.K.
This message is not necessarily news as it was what we initially detailed in our May 2013 report. What is different though, is that the bifurcation among the various countries across Europe, the periphery in particular, has become even more pronounced the farther we get from 2010. As a result, we believe that an investor risks potentially overpaying for an asset or buying an asset too early if he or she does not fully appreciate where each country is in its economic life cycle.
Using Our Macro Framework, We See Different Countries Operating in Different Phases of Their Economic Cycles
So to help us better understand the macro in the periphery, we recently developed a macro framework for assessing investment opportunities in the more troubled countries, including Spain, Ireland, Portugal and Greece. It includes five phases in the renewal process and is intended to break down the opportunity sets into somewhat of a macro timeline. Our framework is as follows:
Phase I: Focus solely on local export companies in the periphery that benefit from a recovery in global growth; avoid traditional consumer stories
Phase II: Migrate towards companies that sell into capacity constrained exporters (and the real estate required to build out capacity)
Phase III: Move towards import substitution stories as the export value chain vertically integrates
Phase IV: Find steady/less cyclical consumption stories that benefit from some form of economic recovery. Also, trade-down/substitution stories should work nicely, but remain cautious on traditional cyclical consumer stories
Phase V: Finally, focus on companies that are levered to falling unemployment or benefit from hyper-cyclical industries like advertising, etc.
In terms of specific countries, our research leads us to believe that Ireland is probably the periphery country that has transitioned its economy from Phase I to Phase V. Exports in areas like healthcare, technology and agriculture are now booming, while house prices in Dublin are now up 11% year-over-year4. That is the good news, particularly for improving consumer cyclical parts of the economy. The bad news is that the country is now flush with capital, and as such we see lower return profiles for opportunistic capital, particularly as compared to Phase I through III. See Exhibits 27 and 28 below, but as a proxy for investor perceptions about Ireland, we note that Irish government bond yields have collapsed to below 4% from around 14% in July 2011.
Irish Government Bond Yields Are Now Back to Pre-Crisis Levels…
…And the Yield Curve May Suggest Stronger Growth Ahead
Within Spain, the outlook is more complicated. One the one hand, our prior playbook of focusing on Phase I is now getting a little stale. To review, our original view post our May trip was to avoid consumption-oriented investments and to focus on export-related stories. Key to our thinking was that an investor could get globally competitive companies domiciled in Spain at discounted Spanish equity prices with upside to both margins and improved financing costs. After this latest visit however, it is seems that the consensus – and all the capital that typically follows the consensus – is now extremely focused on export-related stories, making this area of the market less attractive on the margin.
On the other hand, we think that there are two important positive knock-on effects from a robust export cycle worth considering in Spain. First is that many Spanish exporters are now running out of capacity. To put this in context, consider that investment in Spanish machinery and equipment is now just 5.7% of GDP, down a full 26% since 20085. As a result, Spanish exporters are now being forced to play catch up by finally reinvesting back in their businesses. For a country that may endure another 7% decline in overall fixed investment in 2013, this pocket of strength is notable.6 Second, as Spanish companies become more competitive exporters, they are bringing more of the intermediate goods assembly in-house via vertical integration. Not surprisingly, this initiative likely could mean more jobs, more investment and more efficient Spanish exporters.
Meanwhile, our research still leads us to believe that periphery countries like Portugal and Greece have not had enough economic momentum for folks to move past Phase I or Phase II investment considerations. True, overall exports have grown, but the knock-on effect to related industries has been noticeably more muted than in Spain or Ireland. Moreover, high unemployment and a weakened government sector likely mean more weakness in consumer cyclical industries, including traditional media.
Private Sector Borrowing Remains Outsized In Portugal, Particularly Relative to Overall Economic Development
In Certain Countries the Growth Outlook Remains Constrained by an Overhang of Debt and Overconsumption
So our bottom line is that while the periphery appears to be recovering, knowing where and when to deploy capital is becoming increasingly important. The good news is that there is still not enough foreign direct investment in many of these countries; nor is there enough bank capacity in many instances. As such, we believe there is opportunity for investors with strong knowledge about refinancing and recapitalization options, particularly those with a local presence, in our view. But as more capital comes back to Europe and the difference between many countries gets further extended, we think understanding the macro trends of where a country’s economy is in its own revitalization process has now become of paramount importance.
A Potential Turn in Central Bank Policy?
As we mentioned earlier, we think central banks in the region, the ECB in particular, need to do more to promote growth. If there is good news, it is that we are finally beginning to see efforts to make quantitative easing (QE) more effective by making it more targeted. Indeed, similar to Ben Bernanke focusing more heavily on buying mortgages to restimulate housing in the United States, European authorities are now focused on promoting growth in cyclical sectors. For example, in the United Kingdom we have already seen the introduction of a Funding for Lending Scheme, which basically rewards banks that make loans to small-to-medium size businesses with more favorable capital treatment. There is also a new U.K. program called Help for Lending that is gaining traction by providing a vehicle for new homeowners to have the government help reduce the overall magnitude of initial down payment.
Meanwhile, we think the ECB’s recent decision to provide more liquidity to small-to-medium size asset backed lending products is another step in the right direction. Separately, we were also encouraged to see news in July that Germany will contribute, via its KfW Development Bank, up to €100 million to provide Greek SMEs with better access to affordable financing.7 While small in absolute terms, the investment is a token of Finance Minister Schaeuble’s commitment to “quicker support with tangible, psychologically effective results in a manageable period of time8.”
ECB Balance Sheet Is Now Shrinking as the Federal Reserve and Bank Of Japan Expand Through Further Monetary Stimulus
Cyclical Economy In U.K. May Start to Accelerate, Compliments of a More Targeted Focus
So if our thesis is right about the Bank of England and the European Central Bank intending to do even more targeted stimulus, then the investment implication, we believe, is quite significant for long-term investors. Specifically, we think the shift from blunt QE towards more targeted private sector initiatives could help to finally revive more cyclical parts of the European economy. We have been heavily focused on this issue for quite some time because, as a quantitative GDP model for Europe shows (Exhibit 33), almost all the positive influence of easier financial conditions is being offset by lack of cyclical follow-through to the real estate, construction and other cyclical industries. Given how much of a drag the cyclical sector is now on the overall economy, our base view is that literally almost any additional initiative to stimulate growth in areas like real estate, autos and machinery could have a major impact on our growth forecast.
Our Eurozone GDP Growth Model Would Benefit Mightily From Central Bank Initiatives to Stimulate the Private Cyclical Sectors
Both Private and Government Real Consumption Have Improved
Banking Outlook: The End of the “Misalignment Triangle”
Truth be told, my most recent visit to the Continent was the first one in years where a bank executive did not need to get up, leave or cut a meeting short because of funding concerns in the sector. So naturally, I left places like Madrid, Spain and Dublin feeling better about the banking sector. No doubt a low bogey, we fully acknowledge. But I do think it provides some color on how much the overall story has improved towards stabilization from pure chaos.
The Misalignment Triangle Has Kept Europe in a Holding Pattern Over the Past Few Years
Today if we use Spain as a proxy for the overall health of the banking system in Europe, there are several things to consider, we believe. First, the crisis is now running on three years, so many executives seem to feel confident that they now have a much better understanding of the risks in their portfolio. They likely should, given that – outside of their own substantial internal provisioning – the sector has been allocated $50 billion of external capital from the Troika. Finally, underwriting and marking standards have gotten tougher. Already, the government has mandated write-down guidelines on real-estate related loans and despite these tougher standards, we are now finally in the camp that non-performing loans in Spain could peak by 4Q13.
Loans to Non-Financial Corporates Are Down 20% From 2012
Positive Net Exports and a Smaller Consumption Drag Are Giving Spanish Real GDP Growth a Lift
However, our bigger picture conclusion is that the European banking system still faces what we classify as a classic “misalignment triangle,” a game theory-like principal that suggests none of the participants in the game are currently incentivized to affect positive change. Here’s our thinking. At one corner of the triangle sits the European Central Bank, which has not wanted to provide more capital to the banks until it assumes its role as ultimate supervisor in 2014. At another corner is a collection of country governments, many of which are too levered themselves to provide additional capital to the banks. At the final corner of the triangle are private investors, many of whom are too skeptical of the banks’ marks to provide capital at levels the bank executives feel is not overly dilutive.
But the good news, we believe is that the current misalignment triangle is finally on track to be broken when the ECB flexes its new muscle as the region’s new bank supervisor in 2014. In our view, this transition is a big deal and is being potentially underappreciated by the market. In particular, if the ECB is able to shape behavior the way we think it will, it could potentially help to “fix” two key lending headwinds that are deterring a normalization towards potential growth: cross-border lending and lack of available credit for small to medium sized business. One can see that in Exhibits 38 and 39.
Cross-Border Lending in the Eurozone Has Collapsed and Is Now In Need of Repair
Spread Between SME Loans In Spain and Germany at an All-Time High (MFI Lending Rates On Loans of Less Than €1M)
So how will the ECB hand-over work and what are the upcoming milestones on which investors should focus? First, our research shows that by summer 2014 the European Banking Authority (EBA) will conclude its Asset Quality Review (AQR) of 170 banks within the full European Union.9 Not surprisingly, it will focus on the asset side of the ledger. In particular, we believe that the AQR will focus on standardizing asset valuation across the region, with specific focus on the issue of restructured vs. non-performing loans, and the valuation / reserves of those loans. In addition, we believe there will also be a notable focus on legacy Commercial Real Estate (CRE), construction and shipping assets.
At the same time the EBA will oversee the AQR, the ECB will administer a Balance Sheet Assessment to approximately 124 systemically important banks within its smaller Eurozone coverage universe. In terms of simplicity, the good news is that the ECB will use the same playbook on the asset side of the balance sheet as the EBA. The bad news is that on the liability side of the balance sheet, it will determine its own criteria.
Besides the need to better understand the liability guidelines, we still also do not know whether results will be disclosed immediately – and if so, how? This is a key point as it will obviously affect the need to attract private capital as well as the desire by all parties to keep the capital markets functioning properly.
Thereafter, a formal stress test will again be initiated, but this time it will be run by the ECB, not the EBA. This baton hand-off is an important change, we believe, as the ECB’s oversight should add more credibility to the process. Administering the test will be 1,000 ECB officials, 500 of whom will be selected from national central banks as well as 500 ECB new hires. Importantly, local regulators will not oversee local banks in their local jurisdictions. As a result, there should be less likelihood of favoring local champions at the expense of foreign banks operating in a country.
So our bottom line is that we find the proposed structure for finally addressing the banking system’s capital adequacy to be an objective structure. In particular, we think the introduction of the ECB into the process is an important positive. In addition, the European Stability Mechanism (ESM) now stands ready with €300B euros of loan recap capital, €60B of direct bank equity recap capital, and €40B for non-euro country bailouts. Finally, Europe also has the LTRO and the Outright Monetary Transactions (OMT) as broad-based ECB mandated overlays. However, even with these new tools, there is also more work to do to bring banking reform to fruition. So from our vantage point, the next few months represent a critical time for all the various constituents in this complex oversight process to speak more frankly and more directly with each other if they are going to finally improve the functioning of a banking system whose assets represent 3x the region’s GDP.
But even with the positive momentum, the European financial services system still lacks a major presence in a key area of the global corporate funding market. Specifically, we think there must be a significant push by regulators, bank executives and investors to increase both the breadth and depth of the region’s capital markets. All told, Europe non-financial corporates get just 11% of their funding from bonds (Exhibit 40), relying heavily instead on bank loans; by comparison, in the U.S. tradable corporate credit accounts for fully 67% of funding.10 In our view, Europe needs to do more to build its tradable bond market so that credit risks can not only be better dispersed but also to help reduce overall dependence on bank balance sheets. Moreover, by having a larger portion of credit risks actively traded will create greater transparency on pricing, something that has clearly been missing during the most recent period of deleveraging.
Euro Area Bond Borrowing Still Just a Small Percentage of Total Corporate Debt
No doubt, Europe remains a cumbersome and sometimes frustrating place to invest. Without question, there are complexities associated with investing in Europe that may deter certain investors. But with the German elections behind us and the global economy now recovering, we still see more upside ahead across the steadily improving capital structures of many European corporations and financial institutions.
Against this backdrop, we continue to champion many of the same investment themes: consumer trade down/substitution, exports outside of the Continent, debt for equity deleveraging stories, logistics/energy efficiency, and technology/media transformations. We also think some of the emerging areas around Europe, including Africa and the Middle East warrant investor attention. Finally, the accelerating remediation of the European financial services industry, which now finally seems poised to occur under the ECB’s leadership, also represents an important long-tail opportunity. Moreover, if we are right about the changes that the ECB can effect, then greater transparency should be long-term bullish for regional growth, equity valuations and credit spreads.
Europe Is Now Trading at a 32% Discount to the U.S.
Sector Adjusted Europe Still Trades at a 9% Discount, Despite Below Trend Margins and ROE
And while we feel good about our positive marginal macro thesis in Europe, we certainly expect bumps and scary headlines along the way. Portugal and Greece will likely both need more capital, while Italy is now experiencing both slow growth and lagging productivity. Moreover, from a pure macro perspective, the European Union framework can be clumsy at times, deleveraging will take time and the region’s demographics remain poor. As such, the key to success in Europe will likely mean not only being selective but also leveraging local relationships and industry knowledge to deploy capital, particularly during periods of uncertainty. But as was the case in Asia after its debt crisis, volatility and dislocation create uncertainty. So in our mind, we now think the region offers attractive upside investment opportunities, particularly for long-term investors with patient capital, sound underwriting skills and the ability to invest across the entire capital structure as warranted.
- 1 Data as at September 30, 2013. Source: Statistical Office of the European Communities, Haver Analytics.
- 2 Data as at September 30, 2013. Source: Bloomberg.
- 3 Ibid.2.
- 4 Data as at August 31 2013. Source: Central Statistics Office Ireland, Haver Analytics.
- 5 Data as at 2Q13. Source: BBVA Research.
- 6 Data as at September 30, 2013. Source: Banco de España, Haver Analytics.
- 7 Schaeuble Flies to Athens as Merkel Government Resists Debt Cut, July 17, 2013. Source: Bloomberg.
- 8 Letter to German Economy Minister Philipp Roesler, dated May 21, 2013. Source: Bloomberg, May 28, 2013.
- 9 Details of the European Central Bank’s proposals for stress testing banks and the Asset Quality Review can be found at: http://www.ecb.europa.eu/ecb/html/index.en.html
- 10 Data as at October 15, 2013. Source: ISI.
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