Almost a year since Greece’s debt fiasco first came to light, the eurozone debt crisis continues to grab headlines, with Portugal’s sovereign debt recently suffering a string of downgrades from rating agencies. So where does the eurozone stand on growth, bailouts and common currency, and what does this mean for European equity markets?
It’s a lofty question with no single answer, not least because euro woes and peripheral debt angst are influenced to a degree by political considerations and perception of risk, in addition to more straightforward economics.
Sharing their outlook for the European economy and investment climate a year after the eurozone’s sovereign debt crisis first hit the headlines, Azad Zangana, European Economist at Schroders, shared his outlook on the European economy and Rory Bateman, Schroders’ Head of European Equities and manager of the Schroder ISF European Large Cap fund, argued that there’s currently a strong case for investing in European equity.
One of the key factors behind this view is that an overspill of debt woes from Portugal to Spain would be unjustified given the latter’s fiscal position. This belief suggests that the eurozone in its current makeup will be able to sustain its sovereign bailout commitments, even if that includes propping up Portugal with a loan. It also creates grounds to believe that the EU’s economic recovery, as two-speed as it may be, will maintain momentum and support corporate health. Against this background, the economist and fund manager believe European equity valuations present investment opportunities. “European equities are cheap relative to other regions,” commented Bateman, adding that “convergence of the valuation gap” is bound to occur in this view.
Bailout Maths
Much to the dismay of Portuguese statesmen and businessmen alike, sovereign debt markets have been essentially pricing in a third eurozone bailout. Portuguese bonds have taken a hammering of late and the most recent rating agencies moves have fuelled the fire under Portugal’s debt cauldron. The fact that Portuguese government bond yields stand at a euro-era high is as much yesterday’s news as it looks to be tomorrow’s, unless the European Financial Stability Facility (EFSF) is called to the rescue. Today’s bond auction by the Portuguese government may have been successful but it’s only a temporary sticky plaster. Large redemptions due in the coming months are likely to force Portugal to seek the help of the IMF/EU fund.
At this point in the game, an EFSF bailout of Portugal could be seen as necessary to put a lid on the eurozone debt fears. Supporting Portugal financially will be “a positive step”, commented Zangana. He pointed out that a third bailout package will not be a “tremendous strain” on eurozone finances and it would boost confidence in the ability of the single currency zone to resolve its fiscal imbalances.
A little less than a year after the first eurozone bailout package was administered to Greece and four months after Ireland reluctantly received theirs, the logic that an EFSF loan can induce debt market confidence is beginning to sound all too familiar. But making the assumption that history will repeat itself is both frightening and potentially wrong. There are a number of ways the sovereign bailout story may go this time round.
The worst case scenario looks at a trillion euros of Europe’s money allocated towards financing sovereign debt, sovereign debt defaults or even the end of the common currency as we know it. In assessing the combination of short-term pressures from increasing minimum debt payments and interest charges with the longer-term burden of structural deficits, Zangana has six eurozone countries on his list of “troubled sovereigns.” To the usual suspects, Greece, Ireland and Portugal, he has added Spain, Italy and Belgium. The government debt due for refinancing between 2011 and 2018 of these six countries amounts to EUR 2.9 trillion – a bite on which the EFSF might easily choke, in Zangana’s view.
There has been much speculation that, faced with such a reality, one of the prime contributors to the EFSF, Germany, could be tempted to abandon its financial responsibilities and the eurozone altogether. Another possibility is that fiscal austerity measures and monetary tightening convince Southern European states to leave the euro. The third possibility Zangana outlined is that in the process of ensuring fiscal stability, the eurozone becomes more integrated, but individual member states shed more of their sovereignty.
The best case scenario is that none of this happens. Both Zangana and Bateman were quick to point out that this ‘best case’ is a scenario with a lot of economic sense to it. Looking at spreads of peripheral debt bonds to German Bunds, both Spanish and Italian debt trades tighter than Greek, Portuguese or Irish bonds. In Bateman’s view, this is a signal that the market itself does not expect a domino effect to sweep over the rest of the Iberian peninsula and the Apennines.
This decoupling in fixed income performance can be explained by looking at Spain’s balance sheet, the Schroders’ team pointed out. Spain has entered the credit crisis with considerably lower debt-to-GDP ratio than many eurozone countries, and while the debt levels of its households and financial institutions are high--much higher than that of either Italy, Germany or France--its government obligations are actually lower than the debt to GDP ration in any of these three countries, as well as in the UK. “Spanish banks are not a threat in themselves,” Zangana explained. He said Spain might have a “short-term liquidity problem,” but not a “long-term solvency” issue.
With these observations in mind, the stability of the common currency should not be a pending concern. This is particularly valid in terms of the likelihood of a German withdrawal from the eurozone. As Zangana pointed out, an increasingly large portion of Europe’s growth is driven by exports and, in the case of German companies, the eurozone is the prime recipient of these goods. A change of currency will likely mean an appreciation of the tender Germany chooses, Bateman pointed out, which will hit exporters. In addition, it will leave the euro-denominated balance sheets of German banks “critically impaired.” This logic prompted Bateman to conclude that “the euro is here to stay and we’ve got to start believing it.”
Seeking Opportunities in European Equities
If one does not go for the doom-and-gloom scenario, then European equity markets might appear attractive in terms of both current valuations and economic growth prospects.
Zangana and Bateman agreed that the EU is on the way to recovery, albeit at varying speeds. Although there is a divergence in annual GDP growth between member states, with the core performing strongly and the periphery lagging behind or even contracting, peripheral countries account for only 12% of the total European GDP and in Bateman’s view this is “not sufficient to detract from core Europe’s macroeconomic recovery”. In addition, peripheral countries make up an even smaller portion, 7%, of European equity markets in terms of market capitalisation.
In his portfolio strategy, Bateman outlined core European countries’ economic growth, attractive equity valuations and European companies’ high cash flow generation as prime contributors to the region’s investment appeal. He is encouraged by the redirection of asset flows away from emerging markets and believes that while Europe has thus far not thrived on this trend, its turn is near. He added that Europe usually lags behind the US in terms of capturing interest in developed markets.
Buying at the Point of Fear
As one would expect of the manager of a European large-cap fund, Bateman is bullish on European equities. He likened the current investment climate to the situation in May last year, in that it presents an opportunity to buy at the bottom. “Buying European equities at the point of maximum fear 12 months ago would have yielded strong returns in absolute and relative terms,” he observed. Interest rate hikes, while expected by both the ECB and the Bank of England, will be “symbolic” and the steepness of the rate increase curve will not be sufficient to choke growth and translate into company underperformance, Bateman said.
Peripheral debt sustainability and single currency stability are the two main risks Zangana outlined for Europe, but, as he said, “if you don’t believe risk will materialise, it is a valuation opportunity.” All in all, the Schroders team view is that one man’s concern is another man’s chance to buy a bargain and Europe is the stage at which this familiar financial markets scenario is currently unravelling.
