Climbing a wall of worry ?

Climbing a
wall
of worry

Pascal Blackburne & Luc Synaeghel 2017-03-10

Politics rule our investment letter again this month, albeit shifting focus from the US to Europe. With the first episode of a heavy 2017 electoral agenda just around the corner, investors are understandably concerned that a populist backlash could undermine the European construction. Our position, taking a hard look at each of the countries involved, is that the European Union (EU) will likely not only survive the political challenges of 2017, but perhaps even emerge more united – thus in a better position to rethink its future.

Although Geert Wilders’ Party for Freedom in the Netherlands will undoubtedly claim a strong number of seats in the March 15 Dutch vote, it should fall well short of a majority. Odds then are that a coalition of center-right and center-left pro-EU parties succeeds in forming a government.
In France, Marine Le Pen’s chances of winning the second round of the presidential election on May 7 are deemed low. Were she to pull through nonetheless, she would find herself constrained by the French parliament in any attempt to exit the Eurozone.
And in Germany, a possible September 24 victory of Martin Schulz over Angela Merkel would actually be supportive for Europe, heralding a less austere stance.
Beyond this known timeline are possible elections in Greece – should negotiations around the July debt repayment bring about a 2015-like crisis – and in Italy. The latter would be the more worrisome, not only by virtue of relative economic size but also because of the currently widespread Eurosceptic attitude among the Italian population. Somewhat fortunately though, Matteo Renzi’s sense of urgency regarding the timing of elections seems to have receded.
We also surmise that the European Commission is pressing the Italian President not to call a general election until the formal 2018 due date.
Such a scenario in which 2017 electoral pitfalls are avoided bodes well for European equity market performance, with the added support of improving global growth and a still accommodative central bank. The latter could of course shift gear as the year progresses, due to core inflationary pressures or – more likely – a sheer shortage of German bonds to buy.
But even if the ECB does taper its quantitative easing and European interest rates step up, we would argue that company earnings growth should outweigh valuation pressure, especially considering that European indices are trading at price-to-earnings multiples well below their US peers. Banks should fare particularly well, once dilutive capital increases have been absorbed.
A final word on China, where the ongoing National People’s Congress has signalled not only a continued intent to reduce the export share in the economy and stabilize the financial system but also, interestingly, major investment intentions in the alternative energy space (to bring back “blue skies”) and the intention to let the currency float somewhat more freely.

Steering through electoral turbulences in Europe

 The country that heralds the greatest risk of disruption: Italy

Assessing 2017 political risk takes us on a tour of continental Europe, from the Netherlands this month to Germany in September, via France and (possibly) Greece and Italy.
In the Dutch elections, there is little doubt that the populist Party for Freedom will fare well. According to recent polls, it should emerge as the largest party in the House of Representatives, with some 30 seats of out the total 150. But with no other party willing to join it in a coalition, it will find itself unable to access a governing position. Rather, the numerous pro-EU centrist parties should – after what could be lengthy negotiations – join forces to form a government, leaving Geert Wilders in an opposition role.
Turning to France, the run-up to the presidential election is proving a very twisted plot, in which legal considerations are dominating the necessary economic debate. Polls currently point to Marine Le Pen winning the first round but then losing, by a wide margin, to either centrist Emmanuel Macron or right-wing François Fillon, in the second round. Even if she does come to claim final victory on May 7, her Front National party is unlikely to win the ensuing (June 11/18) legislative elections, meaning that she would be a President without parliamentary backing. This is important to the extent that exiting the euro appears legally difficult without simultaneously initiating a procedure to exit the EU, which in turn would require a change in the French constitution – an act of Parliament.
In Germany, many investors are fretting about a possible Angela Merkel defeat against challenger Martin Schulz, of the center-left Social Democratic Party. From the EU perspective, this would actually be positive: while Angela Merkel is widely (and rightly) regarded as a pillar of the European construction, she has also been the chief proponent of an austere stance that has contributed to the rise of populism across the continent. Of course, she may also decide to retire before the September election, passing the baton to one of her ministers and fellow Christian Democratic Union party members. To varying degrees, most candidates are, however, pro-EU.
A summer Greek saga akin to that of 2015 is a clear possibility, with the country due to repay EUR 7 billion to its Eurozone creditors in July, the IMF not wanting to participate in a deal that does not acknowledge the unsustainability of Greece’s debt, and several EU countries insisting on IMF participation. Such a crisis could bring about new elections, but the outcome would probably be less Eurosceptic this time around, Syriza having lost substantial ground in polls.
We end our European tour with the country that heralds the greatest risk of disruption: Italy. We wrote last month that both former country leader Matteo Renzi and Five Star founder Beppe Grillo were keen on early elections being called. Strangely enough, Matteo Renzi has since changed his tune – possibly because the prevalent Eurosceptic attitude amongst the population raises the odds of a Five Star victory. While the latter has promised not to form a coalition government, the reality is that there are other Eurosceptic parties in Italy with which it could join forces to push through a (constitutionally non-binding) referendum on exiting the Eurozone.

Stronger growth + inflation comeback = ECB Tapering ?

ECB policy is now more politically- than economically-motivated

On the economic front, most indicators are currently pointing to stronger growth across the world. The global manufacturing PMI posted a three-year high last month, consumer confidence continues to improve (with the UK a notable exception) and trade volumes are on the rise in both advanced and emerging economies – notwithstanding President Trump’s protectionist threats.
Europe is no exception to this synchronised improvement, which begs the question of how long the ECB will pursue its quantitative easing. The official message is that asset purchases will continue through 2017 year-end, albeit at a slightly lowered pace as of April (EUR 60 billion per month versus the current EUR 80 billion). With Eurozone headline inflation having just reached the key 2% threshold, for the first time in four years, the central bank is now pointing to (lower) core inflation to justify the pursuit of its program. But it is only a matter of time before recovering oil prices, which have driven up headline inflation data, trickle down through the economy and begin to affect core inflation.
The reality is that ECB policy is now more politically- than economically-motivated. Bond purchases effectively amount to fiscal transfers from the core to the periphery of Europe.
How long this can continue depends largely on Germany’s tolerance threshold with respect to the loss of purchasing power associated with interest rates well below headline inflation.
Populist parties not being much of a factor in Germany, the ECB may well take the risk of disgruntling the population for a while yet.
But then comes a second obstacle: the shrinking pool of available German bonds. Among the rules governing ECB asset purchases is the obligation to buy paper across all Eurozone countries, in proportion to their respective GDP weights rather than the size of their debt pile. Dropping this allocation key would mean punishing countries that have kept their debt under control. Month in and month out, German paper must thus account for 25-30% of ECB purchases. As the available stock of German bonds dwindles, this becomes increasingly challenging. The restriction that only debt with a yield above the ECB deposit facility rate (currently at -0.4%) be bought has already had to be abandoned...
A tapering of ECB purchases thus appears inevitable, sooner probably than most investors expect. Fortunately, the ensuing interest rate increase should matter little at the corporate level. Prospective final demand, rather than the cost of money, is what drives business investment decisions. After nearly a decade of depressed conditions, European companies have also become leaner, meaner and fewer, implying that any sales improvement (thanks to the stronger global environment) should translate into much stronger earnings.
Admittedly this potential earnings leap has already been factored in by analysts, explaining the large gap between the 2016 historical (19x) and 2017 prospective (14.5x) price-to-earnings multiple on the Eurostoxx 50 index. Still, by international standards, European equities look attractive: the S&P 500 index is trading at 18.5x 2017 expected earnings, the Russell 2000 (US small- and mid-caps) at a whopping 27.5x and the Nikkei at 18.3x.

Light at the end of the banking tunnel

European companies have also become leaner, meaner and fewer

Within European stocks, the banking sector is starting to look particularly compelling. After seven years of ECB-abetted balance sheet clean-up, the combination of a stronger economic environment and (down the road) monetary policy normalisation argues for impressive earnings growth. On forward 2017 expected earnings, the European banking sector is currently trading at a price-to-earnings multiple of only 12x.
Of course, a number of banks still require capital increases – and not just in Italy. The good news is that financial markets now seem more open to such operations. The bad news is that they tend to be very dilutive for existing shareholders. Consider for instance the just announced Deutsche Bank EUR 8 billion rights issue, which came at a near 40% discount to the prior closing price. Or the decision released a day earlier by Banco Popular Espanol to raise over EUR 2 billion, with the new shares priced at 35% of the prior close.
With capital increases difficult to predict (bank balance sheets remain very opaque) and, especially, to time, we feel that it is still too early to invest directly in this sector. For the time being, we are happy with the 21.5% financial exposure that our Stoxx 50 holding brings and will be keeping a close watch on how the situation evolves.