The Silver Bullet | Don’t Give up on Europe

“Europe is just uninvestable,” a fund manager declares, while carving a slice of roast lamb over dinner in Mayfair. “With Marine Le Pen in France, Brexit and populists all over the place, we prefer to avoid any Eurozone risk.” The other investors in the room nod, in silence.

The case for investing in the Eurozone assets has never been harder to make. Equipped with sophisticated macro models but sometimes lacking confidence in the EU’s political intricacies, investors often decide to give up on Europe altogether. We have not.

2017 indeed looks like a political minefield for European investors. Anti-euro candidates are gaining ground in the Netherlands and France, both of which have upcoming elections. The UK is about to start its split from the EU and is threatening to implement aggressive tax-cuts to counter investment uncertainty during the negotiating process. Greece’s Syriza government is again struggling to agree on a deal with creditors. Germany will hold elections too, in September, while Italy’s caretaker government is trying to kick the can down the road. As a result of these worries, Italian and French debt has just reached record high spreads not seen since 2014 and 2012, respectively. But beyond the political uncertainty, we believe there are opportunities.

First, growth and inflation continue to accelerate, and in the latest indices of economic surprises Europe has been faring better than the US. While Italy, France and Portugal are lagging, other countries – including Spain and Ireland – are steaming ahead at well over 2% growth. Soft indicators of consumer confidence and business sentiment are also breaking new highs. Reflating policies from the Trump administration and a stronger dollar will likely lift Eurozone exports further over the coming months.

Second, there is still a potentially positive outcome for European politics. Yes, populist candidates Geert Wilders in the Netherlands and Le Pen in France have gained ground, but they remain head-to-head with others.

In France, both Emmanuel Macron and François Fillon support domestic reforms and want more, not less European integration. A potential victory of Mr Macron over Le Pen, combined with the re-election of Angela Merkel in Germany, would create a strong pro-reform Franco-German coalition. At that point, the EU could finally build stronger ties (which will be easier after the departure of Britain, which was always lukewarm about the European project). Our estimates show a high probability of Le Pen passing the first round, but a very low probability of victory.

Third, the European Central Bank’s monetary policy stimulus is finally starting to benefit the real economy, not just financial markets.

Since last summer, the central bank has started to focus on the banking system as its transmission channel for Quantitative Easing. This is key in Europe, where contrary to the US, banks provide three quarters of credit to firms, and loan-funded small businesses create 80% of new jobs. It means we should see a boost in lending to the real economy, which could turn into much-needed investment and job creation.

Until now, the biggest obstacle to credit transmission was the poor health of Eurozone  banks, still encumbered by €1 trillion of bad loans and overblown balance sheets of around €31 trillion, three times the size of the economy – against an average of one to two times elsewhere in the world. But today banks are on the mend, having added over €260 billion of capital since 2010, and the ECB’s plan is now starting to bear fruit. Having signalled less – not more purchases of bonds since last summer – the central bank steepened the long-end part of the yield curve, boosting profitability and equity valuations of banks. The supply of loans to non-financial firms, which had been falling for several years, is now gaining pace and has risen by 2% year-on-year in December.

Despite these improvements, investors are giving Europe tough love. European stocks cost $12.75 for every $1 of future earnings; vs nearly $16-17 in the US and Japan. German and French government bonds yield 1% below inflation over 10 years, a hefty negative real return. Bonds perceived as risky, like the ones issued by Greece or subordinated bank debt, offer some of the highest real yields globally, more than frontier emerging markets.

In other words, financial markets discount a near-certain scenario of high growth and inflation in the US, on the policies set by the Trump administration, and a high chance of break-up risk in Europe. We think the future will be different.

In the decades before the financial crisis, Eurozone countries lagged behind the US and the UK, held back partly by higher taxes, less flexible labour markets and more generous welfare policies. But the financial crisis taught us that this pre-crisis growth cycle built on credit, rising asset prices and stagnant productivity is neither replicable nor sustainable.

What is left today of this asset-rich, wage-poor growth model is widespread inequality, a disenfranchised generation of young people with no jobs and no assets, and rising populism. Both the US and the UK rank among the top Western countries for inequality, according to OECD data. Against this backdrop, Europe’s social safety net and its inclusive welfare policies could turn into strengths, giving it more social and political stability than investors expect. In a historical twist of events, state leaders in Germany and France have recently reminded the US of the importance of civil rights.

Instead, policies to restrict trade and immigration implemented by the US and UK may provide a short-term boost to growth and inflation, but will likely hurt growth in the long-run.

Many pundits have predicted a Euro breakup since 2008, and have been wrong. Eurozone leaders surely need a re-think of their strategy, as European Council President Tusk said recently. One option is to build a more flexible union – using a “variable geometry” strategy. This would allow potential members to exit lowering the burden on core countries. The other option is of a closer Europe, which both France and Italy support, as well as the new German opposition leader Schulz.

In any case, Eurozone institutions still have plenty of dry powder, including the €500 billion-strong European Financial Stability fund, and Europeans support the EU project even in countries hard-hit by recessions: 73% were either positive or neutral as of mid-2016, according to the European Commission’s eurobarometer. As the political dust settles and attention shifts back to fundamentals, investors may soon find themselves too short on Europe.

Politics: A Positive Scenario After the Dust Settles

France: A Glimmer of Hope against Populism

In France, recent polls suggest that the most likely candidates to make it to the second round are Marine Le Pen for the Front National, former Minister of the Economy Emmanuel Macron for En Marche! and François Fillon for Les Républicains. However, despite Le Pen’s near certainty of winning in the first round, our model suggests that she stands a very low chance of beating either Macron or Fillon in the second round, even after correcting for potential polling biases to favour her. While Le Pen may continue to rise in the polls against Fillon if the latter’s scandal worsens, it seems increasingly likely that the battle will be between Le Pen and Macron. This is positive as Macron has been enjoying a significant and growing lead over Le Pen in polls.

Netherlands: The Winner Doesn’t Take It All

Despite the polling lead by Eurosceptic Geert Wilder’s Freedom Party (PVV), his party will likely fall well short of the 75 Congress seats required to form a standalone majority government – which no party has achieved in the Netherlands since 1900.

We consider the possibility of a Wilders coalition government unlikely, as although he may receive the mandate from the Speaker of the House to attempt a coalition government, he is unlikely to find enough coalition partners. The current ruling, centre-right VVD party (polling second) has ruled out the possibility of a coalition with PVV. Similarly, the remaining major Dutch parties are of centrist or leftist ideology, and hence unlikely to form a coalition with PVV.

Should Wilders fail to form a government, the task will likely fall to the VVD, which is likely to form a multi-party coalition (there are several historical precedents in which the Dutch Government did not include the most voted party, e.g. in 1977). Therefore while Mr Wilders’ nominal victory will create negative headlines, we find it more likely that the PVV remains out of power, which should put to rest any short term concerns about a NExit, if not Dutch governmental stability.

Greece: The Melodrachma Is Back, but with a Happy Ending

The Greek melodrachma is back, but we think there will be a happy ending. We expect more headline volatility over coming weeks, but think a short-term deal between Greece, EU institutions and the IMF is likely. The three sides have conflicting demands. EU institutions want the IMF to participate in Greece’s current three-year bailout programme. On the back of strong tax revenue intake (albeit slow progress on reform implementation), the Greek government is incentivised to refuse additional long term fiscal adjustments floated by creditors as part of the bailout program’s second review. The IMF on the other hand sees these measures as needed for long term debt sustainability, in conjunction with debt relief.

There could be continued brinksmanship over the completion of the bailout’s second review and disboursement, however all parties are incentivised for a deal to pass. With upcoming elections in the Netherlands, France and Germany, neither EU institutions nor the IMF want the stalemate to escalate into a full-blown crisis again. Tsipras may insist on more leniency from the creditors, but is incentivised to accept a deal in order to avoid triggering new elections and losing power. Hence a compromise from all sides is likely, and a final deal could involve some small debt relief measures.

Italy: More Can-Kicking in 2017

Despite the lack of a popular mandate for the caretaker government, we believe there will be no immediate call for elections among a majority of political parties, as other critical and unpopular matters occupy the government’s agenda – including the rebuilding of Italian banks’ balance sheets, which kicked off with UniCredit’s capital raise announcement and the set-up of the bank bailout fund.

However, we also expect a stall in the reform momentum started under former PM Renzi’s administration, leading to a lost opportunity for Italy to streamline its systems and boost growth and productivity.

The Italian Supreme Court’s ruling in January scrapped the electoral law’s (Italicum)  proposed run-off system, which means parliamentary seats will be appointed on a proportional basis if no party wins 40% of the vote in elections. In other words, future elections are likely to continue producing fragmented lower houses, making governing and reforms as difficult as they have traditionally been.

Europe’s Fundamentals: Improving Steadily

Since the launch of QE, inflation has picked up in the Eurozone, unemployment has steadily declined, and both bank and corporate profitability have improved. Since most of credit flows through banks, and bank loans fund most SMEs responsible for job creation, we pay extra attention to any turning point in bank lending activity. While Eurozone banks still need to consolidate and are weighed by non-performing loans, banks fundamentals have improved since the depths of the crisis in 2011. Eurozone banks have raised more than €260bn in capital since 2010, and non-performing loans have declined from around 5.3% in Q4 2013 to 4.1% in 2016 (ECB). A stronger balance sheet, combined with monetary easing, has helped boost bank lending. Lending to SMEs, which contribute to 80% of employment in the Eurozone, has continued to improve. As shown left, bank lending to non-financial corporates has stabilised since 2014 and been gradually improving in 2016.

With easier access to funding and an improving macro-economic backdrop, corporate fundamentals have slowly improved. Since 2015, Eurozone corporate leverage has gradually declined while profitability has improved (see charts below). European businesses are also more confident about the business climate, than they have been in the last five years (source: EC Economic Sentiment Indicator). Their positive outlook has likely contributed to declining unemployment across the Eurozone (from over 12% in 2013 to 9.6% by the end of 2016), and concurrently the decrease in householde leverage in some countries like Spain.

Conclusions: Buy Europe. It’s Still on Sale

1. Investors have priced in too much positive news in the US and discounted too much political risk in Europe, in our view.
2. Fundamentals point to a strong Eurozone recovery: a turning point in lending activity could mean more job creation; business sentiment and consumer confidence continue to rise, while inflation and growth are getting close to 2% in core countries.
3. Despite the political worries, we estimate a very low chance of Le Pen winning in France, while in the Netherlands even if Geert Wilders wins, he may have limited control on parliament. On the other hand, a victory by Mr Macron in France combined with the potential re-election of Chancellor Merkel in Germany could create a powerful Franco-German coalition.
4. A Macron-Merkel scenario would be very positive, contrary to current market expectations. It would also mean that Britain’s bargaining power in Brexit negotiations would fall considerably, leaving the EU to focus on its own issues.
5. Over time, both EU and Eurozone members will need to re-think their strategy. While some German leaders today promote a “variable-geometry” approach, which would still allow for members to leave; the scenario may change with new elections – with a higher influence of Mr Schulz. In addition, France and Italy are likely to gain weight following the UK’s departure, and both have maintained a firm pro-EU stance.
6. Strong macro data and a recovery in bank lending also means the European Central Bank will likely look at policy normalization later this year. There are various ways of doing it –normalising deposit rates, for example, would further help bank profitability and at the same time relieve core savers from low interest rates.
7. There’s still value in risky assets across the Eurozone: both stocks and credit offer extra risk premium against other markets. We are positioned for upside in risk assets and for inflation surprises. We are aware – but look through – the political risks. Finally, we stay away from long-dated government debt, on reflation risk and the upcoming normalisation of monetary stimulus.