The Evolving Euro Drama & Investors
Opportunity in the Wings?
The European debt drama has settled into a long-running series complete with plot shifts, character changes and a regular supply of cliff hangers. Although this uncertainty—along with the United States’ own fiscal issues—has resulted in a muted outlook for global growth, it may also present favorable prospects for investors who can identify opportunities among the challenges. To help investors separate the possibilities from the potential pitfalls, we talked with Federated international fixed income manager Ihab Salib and international equity strategist Brian Holland.
Do you believe policy makers can institute the changes necessary to resolve the many issues surrounding the European debt problem?
Salib: Global policy makers such as the European Central Bank (ECB), the European Union (EU) and the International Monetary Fund (IMF) can’t themselves bring about any of these changes. What they can do, and what we believe they are attempting to do, albeit with differing degrees of success, is create a framework that puts coordinated support mechanisms into place. Their major role is to reassure the market that individual countries will have adequate time and enough of a safety net to implement necessary, and difficult, structural changes.
Holland: Thus far, most of the solutions have been reactionary and have only begun to address the key problems: the unsustainable debt burdens of many of the EU countries as well as structural reforms and growth initiatives needed to improve the economic health of the region.
What we do know is that there is tremendous will on both sides to keep the EU intact, but how that is accomplished and under what timeframe remains to be seen. Changes will come in the shape of roadmaps to a banking union, a fiscal union and a financing union (i.e., a euro bond). Other longer-term structural issues will also have to be addressed to improve economic growth, labor costs, productivity, welfare benefits, among others, but for now the stability of the banking system and a move toward greater fiscal integration are on the front burner.
How do your views on the European debt dilemma translate into investment strategy?
Salib: Prior to 2007, and especially before the major euro-debt issues came to light in 2009-2010, during Greece’s financial collapse, fixed-income securities among European countries generally traded within a very narrow range. Whether buying securities from Ireland, Germany or Spain, for example, the spread between countries was virtually non-existent; there was no risk premium to speak of. At one point in 2006, the yields in Ireland were lower than they were in Germany. The only real decision point within Europe was more about interest rates rather than credit quality.
Today, opportunities on interest rates are subdued given the low global rate environment. There is much more variability—and therefore more opportunity—on the credit side but also more risk. You have to look at what the market is offering in certain countries and determine, for example, would you rather invest in a five-year German security at 40 basis points or hold a five-year Spanish or Italian bond at 4% or 4.5%? What is the risk versus opportunity equation of that decision?
We look at the European market from two perspectives. First, there are short-term, tactical investments driven by upcoming events, such as a vote on the European Stability Mechanism, the implementation of an ECB policy, a Greek bailout, election or whatever else may arise. So short term, you need to be nimble so that you can quickly make adjustments as you anticipate market shifts. Second, for medium-to-long term investment horizons, it is important to consider whether the fundamentals are improving and if implementation of needed structural changes are on track within individual countries. You look two years out to evaluate where Spain, Italy and other countries will be in terms of labor productivity, competitiveness and instituting economic reforms. In other words, how is the overall goal of achieving fiscal integration within the EU progressing? In making these longer-term calls, it’s understood that none of the policies were designed to work in a few months. That is why it is essential to take the long view, be extremely disciplined about your investment criteria and monitor progress as the changes unfold.
Holland: The European sovereign debt issue has raised the importance of country and security selection. A typical response to the crisis would be to underweight European equities broadly given the uncertainties that persist in the region. In our view, such action is like throwing the baby out with the bath water. But with uncertainty comes opportunity and we believe there are many longer-term investments that should provide investors with significant capital appreciation over the next three to five years given the relatively low valuations across the region. There are many global franchises which are trading at attractive levels simply because their companies are domiciled or their shares are traded in Europe. This very fact makes for some interesting investment opportunities, although investors have to take into account characteristics such as sovereign or corporate quality; economic or corporate growth prospects and currency risk.
From a macro/country perspective, the northern European economies have continued to rate favorably in terms of sovereign quality (current account surpluses, lower debt/GDP, etc.) and growth potential. The long-term fundamentals carry significant weight, so it remains important to focus on companies and industries that have strong long-term growth potential, solid balance sheets, strong cash flow generation capabilities that have cyclical or secular catalysts, and are selling below their intrinsic business value.
What opportunities are you seeing?
Salib: There are many. But when it comes to the European Monetary Union (EMU), investors first have to make the decision about whether European leaders can achieve an economic, fiscal and banking union over the next several years—underpinned by greater accountability. If you believe they and the euro will fail, then you don’t want to invest anywhere within the EMU on a short- or long-term basis. But if you believe, as we do, that despite shorter-term uncertainty and volatility, the euro will prevail with politicians and policymakers implementing necessary reforms and structures, it’s important to focus on countries that are more disciplined and aggressive about making necessary structural changes.
For example, although Spain currently holds a low investment rating and faces problems in getting market access to funding, the country has been making significant strides in addressing its fiscal shortcomings on both the austerity side and on growth. By contrast France, which has the lowest funding cost for its debt, is not adequately addressing its fiscal problems. Like the U.S., France has a better cushion and the market is giving them more leeway. But longer-term, they are facing substantial challenges given their lack of action on reigning in spending, simplifying a burdensome bureaucracy and making their labor force more competitive.
Also within the EMU are fiscally strong countries like Germany and Finland. Although Finland’s economy has more recently struggled, the country benefited by avoiding the extreme boom in its housing market, so it didn’t become dependent on fast-rising tax revenues. Like Germany, they made their adjustments to debt and to enhancing labor productivity and global competitiveness early in the decade.
Outside of the EMU, northern region countries are fundamentally sound. Norway, for example, has a very strong economy, partly because of its oil revenues as well as the strong comeback of its housing market. In fact, based on the strength of its economy, Norway is in position to raise interest rates. Sweden, despite its recent slowdown, is another solid performer. Many eastern European countries, such as Poland, Hungary and Latvia are in relatively sound fiscal position, but their growth is closely tied to Western Europe, so as prospects for Western Europe improves, so will their own.
Holland: From a macro and country view, our favorite European equity markets over the next 12-to-24 months—using valuation, growth potential, sovereign and corporate quality as prime investment considerations—are Norway, Germany and Denmark. Germany’s labor market remains strong; its export-driven economy has continued to grow despite the EU slowdown; valuations remain compelling and
corporate balance sheets are very healthy. Norway has the highest potential for corporate earnings per share growth, has strong GDP growth compared to its long term trend, and has the highest quality sovereign credit. Denmark, similarly, scores highly on corporate quality, forward earnings per share growth, and sovereign credit. We continue to avoid southern European countries such as Portugal, Ireland and Spain that continue to struggle, particularly from sovereign debt and economic growth perspectives.
On a more fundamental basis, we believe the best opportunities will be among industries and companies that are “price-setters,” those with strong balances sheets, significant cash flow and earnings potential and that are attractively valued relative to that potential. That generally leads to firms that have geographically diversified revenue streams and have high and growing exposure to the emerging markets. At the industry level, Consumer Discretionary (luxury goods and autos), Industrials (capital goods, trucks, airports and staffing), Materials (cement, building materials, etc.), and select Financials (global franchises). We continue to have a negative view on areas such as Telecomm, Health Care and Utilities where dividend reductions are likely due to margin pressure and valuations that are unattractive relative to historical averages.
Overall, we believe companies and industries that are more domestically focused in Europe will remain less attractive.
What is your view on the eurozone as it relates to China and other emerging economies?
Salib: China will be a global economic driver for many years to come—as will other emerging countries. China’s intent is to engineer a more domestically driven economy, moving away from its current export-led focus. This won’t happen overnight, and exports will remain important to its growth. China is a very big market for European goods and vice versa so a decrease in economic activity of either one affects the other. One of the biggest connections between China and Europe is on the automotive side. The well-known German luxury car makers and other high-end European companies rely on China for their growth. In some ways the impact on China has been more pronounced given the reduction in low-end Chinese imports due to Europe’s economic slowdown. So although China’s and other markets’ participation in the European economy is important, it is one of many factors, especially when you consider that approximately 60% of EU trade occurs within the EU.
Holland: Obviously, the austerity measures and economic slowdown in Europe have had a negative impact on its major trading partners. What the crisis has brought to investors’ attention is how global imbalances and debt can impact the world’s economy and its equity and fixed income markets. Today, many emerging markets are better positioned to weather a global slowdown than they have in past downturns. Countries like China and Brazil, due to their strong sovereign balance sheets and flexible monetary and fiscal policies, can mute the impact through interest rate easing and stimulus spending to encourage domestic consumption and economic activity. Countries more highly geared to the EU and more highly leveraged are at greater risk, such as Poland, Hungary and the Czech Republic. The current economic slowdown has created opportunities for investors wishing to gain exposure, directly or indirectly, to the secular emerging market consumption story.
What markets do you think have the most potential around the world right now?
Salib: From a fixed-income perspective, it is important to look at potential currency effects, interest rates and credit quality. Medium to longer term, we believe emerging markets have much better prospects than advanced economies, with growth in many of these countries likely to be 3.5% to 4.5% higher. Within the developed world, countries that are rich in commodities such as Norway, Australia and Canada are good prospects because of their resources, fundamentally strong economies and fiscal soundness. None of these opportunities are static so they need to be monitored constantly. For example, if the U.S. would fail to get its fiscal situation in order or if China experienced a largerthan- expected slowdown, that would have a strong dampening effect on global energy and commodity markets.
Holland: Like Ihab, our view is that, over the long term, emerging markets will outperform their developed market peers. Emerging markets are not a single entity; they exist along a continuum from less-developed, frontier markets to the almost-developed countries. There are many emerging markets that look more developed from a variety of metrics, per capita GDP, household debt/GDP, etc., in which we see limited potential. There are others that have more favorable growth characteristics: rising wage levels, increasing household wealth, low levels of household and sovereign debt, attractive demographics and growing domestic consumption that we believe the greatest opportunities exist. Countries, industries and companies exposed to these markets are poised to experience above average growth for many years to come as this secular trend plays out.
Currently, we believe Mexico, Brazil, South Korea and China have excellent prospects. Other countries appear attractive from a growth and consumption perspective, such as Indonesia and India, but the valuations of their equity markets reflect the market’s expectations at the present time. Mexico and Brazil are attractive given their young demographic profiles, growing consumerism and solid fundamentals. South Korea has strong global corporations, attractive valuations, and a cheap currency. China has monetary and fiscal flexibility, a huge and fast-growing middle class, attractive valuations despite the recent share rally, and is transforming away from its role as the world’s factory to a more technologically advanced economy. With new leadership in place, we expect continued reforms to occur in social welfare, healthcare, urbanization and in its financial system which will positively affect the economy and equity markets.
How might leadership changes, particularly Germany’s upcoming election, influence this situation?
Salib: Throughout this crisis, leadership changes have occurred in France, Italy and Greece, among other countries. The German elections will be carefully watched, of course, because these elections have the potential to disrupt the somewhat fragile agreements forged among political leaders. Newly elected leaders can come in with what they might perceive as a mandate to change policies that they believe haven’t been working. If you get too much of this type of thinking, fragmentation can again take hold, which obviously hinders the process.
But as years of negotiations have continued, it appears that political leaders have come to realize that forging a consensus is the only way to resolve these complex issues. So they may voice strong disagreements, but in the end they know they need to come up with solutions that are acceptable to the markets. If Germany elects a new chancellor, I don’t see that changing.
Holland: Our view is that after the elections in Germany, and depending on the outcome in Italy, the demands of policy makers will likely be focused on economic growth through reforms. By the time the elections have taken place, we will be looking at nine to 10 months of sluggish or no growth across Europe. Because there is no money for stimulus, the only route will be through reforms, which work slowly. Current expectations are for reaccelerating growth in Germany, at least by the fourth quarter of 2013; however, not in Italy and France until early 2014.
- Although the eurozone debt crisis is far from resolved, the debate may be moving in a more constructive direction with policy makers increasingly focused on what must be changed to avoid future problems.
- The European debt issues that make the headlines also serve to create opportunities. Changing market dynamics and differences among European countries, regions, industries and companies favor investors prepared to be cautious and selective.
- From both a sovereign debt and economic growth standpoint, European countries and companies with ties to other markets, particularly faster-growing emerging economies, offer better investment opportunities as the European drama continues to unfold.