Quality milestone in the European recovery story

March 17, 2014

  • Business, economic and political news all point to a strengthening recovery in Europe.
  • We foresee a period of low inflation and low interest rates in Europe.
  • We favor domestic European plays over internationally-exposed stocks, with an overweight stance in banking and telecoms.

By Paul Doyle, Head of Europe ex. UK equities and Frederic Jeanmaire, Fund Manager, Threadneedle Investments

After 18 consecutive negative months, the flow of eurozone bank loans into the private sector finally turned positive in January. This marks a milestone on the path towards Europe’s economic recovery.

The turning point in the continent’s fortunes was July 2012 when European Central Bank (ECB) President Mario Draghi gave his “we will do whatever it takes” speech in support of the euro. Since then, there have been other indications that an economic dawn may finally be breaking over the eurozone: fourth quarter gross domestic product (GDP) data shows accelerating momentum in the euro area, while a pick-up in business investment suggests that European corporates are reassessing the economic outlook. Purchasing Managers’ Index data for February also underlined the recovery in the European manufacturing sector. This latest bank lending data point, shown in Exhibit 1, indicated that things are finally starting to move in the real economy.

Exhibit 1: European bank lending to the private sector finally turns positive (Euro area bank lending in billions of euros, 2009-2013)

Exhibit 1: European bank lending to the private sector finally turns positive

Source: Datastream, March 2014

There is also clear anecdotal evidence that companies are seeing a recovery in Europe. PPG, the American-based global supplier of paints, has pointed to a “bottoming-out” in Europe, helped by good weather, while Swiss specialty chemicals manufacturer Sika, normally conservative in its forecasts, said that it has enjoyed an “amazing” start to the year in Europe. In addition, Adecco, the staffing company, has reported that revenues in the fourth quarter of 2013 rose by 9% in Italy, 10% in Germany, 12% in Benelux and 7% in the UK. Interestingly France was flat, which shows that the strength of the recovery will be unequally distributed. However, from a low base, there is potential for European growth to catch-up with other faster-growing areas of the globe.

Political news has provided a further boost, with the German Constitutional Court referring the ECB’s Outright Monetary Transactions policy to the European Court of Justice, rather than rejecting it. This has been interpreted as a capitulation by the Germans in terms of their reluctance to support the European Union and the ECB’s backstop, and supports the bullish view of Europe’s prospects. The appointment of reformist Matteo Renzi to the Italian premiership is also encouraging.

Business investment is likely to accelerate further, acting as another support for growth. Corporate cash balances are running at high levels: more than €1 trillion sits on the balance sheets of non-financial companies as a result of the uncertainty of the past few years. Cash-to-asset ratios are close to their 2005 highs of 9.5% for constituents of the Euro Stoxx 600 Index*; last time round this presaged a capital expenditure and M&A boom in Europe.

Exhibit 2: Eurozone non-residential capex as a share of GDP

Exhibit 2: Eurozone non-residential capex as a share of GDP

Source: JP Morgan Equity Strategy, December 2013

An increase in average net debt/EBITDA to 2x from the current 1.6x would provide €400 billion of firepower for growth. As with U.S. corporates, the short-term focus is likely to be on share buybacks and dividends rather than increasing capex. But in a low-inflation/low-interest-rate world, pressure for increased capex and M&A is building. The main risk is that turmoil among emerging markets undermines business confidence and delays the capex/M&A cycle once again, but any slowdown would prompt stimulatory action from the ECB — ironically just as the U.S. is intent on ending quantitative easing.

There are also fears of deflation, which we think are misplaced. If current German wage growth of around 3.5% persists, Europe is likely to experience a period of disinflation and low rates. This would only deteriorate into a deflationary spiral should German wage growth fall below 2%, but few expect this to happen. What is more, to achieve the ECB’s medium-term inflation target of 2%, aggregate euro area wage growth needs to be around 2% higher than productivity. This suggests that the ECB could embark on further unconventional monetary tools to prop up inflation and eventually drive growth in Europe.

The eurozone would function more smoothly if the large gap in competitiveness between Germany and other major eurozone economies closes. Thus, wages need to rise in Germany and fall in the rest of Europe and thankfully this is happening, albeit slowly. Cultural and political factors in Germany provide a brake on wage growth, while German industry faces ever-present competitive forces from its neighbors in Central and Eastern Europe. Downward pressure on currencies in those countries also hinders German wage growth. The problem challenging Mr Draghi and the ECB’s inflation target is that while German wages are currently growing around 2% ahead of underlying productivity growth (so adding two percentage points to inflation), wage growth elsewhere in Europe is barely beating productivity growth, limiting inflationary pressures. This means that given the disinflationary pressure from emerging markets, we foresee a period of low inflation and low interest rates in Europe.

Finally, we find the differential in GDP estimates between Europe and other regions globally particularly interesting. The current consensus is that the eurozone will see GDP growth of 1.1% in 2014, compared with 2.9% in the U.S., and 6.3% in Asia. Should this growth gap narrow, we could see further inflows into European funds, and we believe this is one of the reasons why the euro is currently strengthening.

So we remain optimistic on Europe’s recovery and recent data points only reinforce this. Within our funds, we favor domestic plays over internationally-exposed stocks, and hence have an overweight stance in the banking and telecoms sectors. Europe’s diverse markets give us a vast and varied opportunity set.

 

*The STOXX Europe 600 Index is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index.