Greece’s position in the euro remains uncertain, fighting continues in Eastern Ukraine while the political backdrop elsewhere in the region hardly inspires confidence.
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However, the reappearance of the green shoots of economic recovery combined with the European Central Bank’s ever-more-muscular monetary posture are among the reasons keeping us positive on continental European equities.
As the investment world frets about Greece’s membership of the euro once more, it is worth taking a step back and reminding ourselves that the borders and governance structure of continental Europe have been in a state of near-constant flux for as long as mankind has had the tools to describe it. From the peak of the Roman Empire through to Napoleon’s hard-fought empire of the early 19th century and beyond, the map of Europe has rarely been stable for long.
Such historical perspective is useful for reminding ourselves that many of the countries that actually make up the modern euro area are themselves the product of unions that only occurred in the last couple of centuries. The formal unification of Germany into a politically and administratively integrated nation state officially occurred in 1871. The last dramatic redrawing of her borders happened in 1990 with the reunification of East and West Germany.1 We should be wary of commentators and politicians telling us that the euro’s collapse is all but inevitable because of a lack of common political identity, insurmountable cultural barriers or the secession of one of its members.
It is also a reminder that the euro is part of a much longer trend towards fewer and fewer political authorities the world over. The more global nature of the threats and opportunities mankind now faces should, in theory, continue to force more globally organised institutions – the euro currency is perhaps best seen as a part of this trend.
Of course, Greece could soon go the other way, as already suggested. If it did, you can guarantee that many would then begin to talk about the return of ‘redenomination risk’ (which country is next?). We explore the possibility in a bit more detail below, but with or without Greece, we suspect the euro remains largely intact. The painstaking (and regularly frustrating to watch) construction of a credible fiscal and political architecture will continue, driven forward by the weight of history and, in reality, the lack of credible alternatives. This is part of the story behind our continuing preference for continental European equities; we explore this and some of the other factors in a bit more detail below.
With or without Greece, we suspect the euro remains largely intact
Following the twists and turns of the negotiations between Greece and her various creditors is dizzying and mostly unrewarding. Since we are not suggesting investment in specific Greek assets, the question that matters for us is whether or not Greece will remain in the euro.
The problem is the same as it’s been for some time – Greece’s debts far exceed its medium-term repayment capacity. The Greek economy is therefore technically insolvent, and debt restructuring will be necessary at some stage. On the other hand, the European Union is unwilling to concede much, if any, ground for fear of granting more oxygen to the anti-euro or anti-austerity political parties gaining ground elsewhere in Europe.
We still suspect that a deal allowing Greece access to a second bailout will eventually be done -the proverbial can will be kicked a little further down the road. Both the Greek public and the elected Greek politicians say they want to remain in the euro. Admittedly, on the other side of the negotiating table, many are muttering that Europe is now better equipped to handle a Greek exit in any case. However, with the green shoots of economic recovery just starting to take hold again in the region, we suspect that euro group politicians are unlikely to want to test the euro area’s still incomplete defences.
As a result, the most likely outcome from all of this is that a second bailout deal is probably agreed upon. In reality, it’s unlikely to look very different from the last Greek bailout deal struck back in 2012, in spite of the various promises made by the current coalition on the campaign trail. However, the potential ramifications of a Greek Exit are still well worth considering for investors in the region as we explore in more detail below.
It is different this time…
Few sentences strike more fear into the hearts of sensible investors than ‘it’s different this time.’ However, it is worth remembering that it is not just different this time, it’s different every single time. History, both recent and distant, can provide a useful context and perspective; however, there are always important differences to take into account.
With regards to the likely effects of a Greek exit on the wider euro, there is little we can be certain of. There certainly is the potential for investors to worry anew about lending to governments perceived to be next in line for an exit. However, with the European Central Bank’s (ECB) sovereign bond-buying programme set to begin in March, government borrowing costs should remain reasonably contained.
Conversely, the sight of Greece’s likely painful exit from the euro may well help extinguish much of the popular support for anti-euro and anti-austerity parties in the likes of Spain. For this reason, Europe may want to make Greece’s exit, if that does come to pass, look as ugly as possible.
In terms of the direct official exposure of the euro area to Greece, the amounts look manageable, even necessarily assuming low recovery values. Factoring in the various loans, rescue funds and intra-Eurosystem liabilities, exposure to the Greek public sector for the European Monetary Union member states is around 3.5% of GDP. At around €330bn, this is certainly not a negligible sum;2 however, as suggested above, even assuming low recovery values, we think this is digestible.
It is also worth considering the change in both the domestic and international economic backdrop since 2012. The world economy is now starting to enjoy the warmth from a broadening US economic recovery, with a well-supported consumption story at its heart. In the euro area, thanks to the range of measures deployed by the ECB, the banking sector now looks more fit for purpose3 while signs of a pickup in intra-euro area investment are increasing. (Figure 2) Unemployment is still worryingly high in certain parts of the euro area, but looks to have peaked (Figure 1), and we suspect it will slowly fall in coming quarters if the pickup in business activity and survey data seen in the last couple of months is sustained (Figure 2). Meanwhile, the recent rise in money circulation is an encouraging signal for prospective GDP growth (Figure 3).
Rebooted transmission mechanism
The rehabilitation of the banking sector is particularly important in Europe as we’ve noted before. A warmer credit backdrop will likely benefit the small- and medium-sized business sector the most. Much of this segment of the economy has been starved of funding, since the ability and appetite of the banks to lend to the riskier areas of the market has shrivelled in the wake of the euro crisis and a more demanding regulatory backdrop. With small and medium-sized enterprises (SMEs) accounting for roughly two-thirds of both jobs and value added within the EU, an easier credit environment, signs of which continue to emerge (Figure 4), will have important ramifications for both the wider economy and the more domestically focused small- and mid-cap sectors.
For the equity market…
For our call on Europe ex UK equities, the prospective international economic backdrop is at least as important as the state of play domestically (Figure 5). We see global growth accelerating a little this year, driven by an increasingly hard-to-dispute US economic recovery. In the last three months, the US labour market has added more jobs than at any time since the late 1990s.5 Higher interest rates are justifiably nearing, and we think the world’s most important capitalist economy has long been capable of digesting tighter monetary policy.
All this suggests that the backdrop for a corporate sector with a revenue footprint as globally diversified as continental Europe’s should be positive in the coming 12 months. We see earnings growth finally starting to pick up from here, as profitability starts to recover some of the ground lost to their US peers over the last few years.
Keep an eye on…
Equities are traditionally the most volatile of the major asset classes. Highly liquid and at the bottom of the food chain in terms of liquidation rights, equities tend to be the first way for investors to express unease with regards to various unfolding events, economic or otherwise around the world. In Europe, there of course remains plenty to watch out for. We have pointed out for some time that until the map of Ukraine, or its membership ambitions with regards to certain Western institutions are addressed, a lasting peace is sadly hard to imagine. Financial markets are regularly insensitive to humanitarian tragedies, but the ability of the proxy war still being fought in Eastern Ukraine to crimp European economic activity and therefore equity markets was demonstrated clearly in the second half of last year.
The rest of Europe’s political and social backdrop will remain challenging for a while yet too. The approach of Spanish general elections at year end and ongoing questions over Catalonian independence are worth keeping an eye on. Elsewhere, in France, the current administration’s weak position was recently demonstrated by its recourse to article 39.3 of the French constitution (allowing the government to bypass a vote in parliament) to pass even a very mild programme of reforms into law.
Continental European equities are no longer inexpensive, and there remains much to question with regards to the political backdrop. However, an economic recovery is again taking hold, and earnings estimates may not be far behind. For those investors already up to the weight suggested by their behavioural personality and risk appetite, and who stay the course, we expect to see more upside to come. For those not yet up to weight, Europe ex UK equities remains an interesting way to benefit from the potential for further economic rehabilitation in the region.
Equity investing involves risk including loss of principal. International investing involves a greater degree of risk and increased volatility.
Barclays does not guarantee favourable investment outcomes. Nor does it provide any guarantee against investment losses.
1 US Department of State, Office of the Historian.
2 Barclays Research, Euro Themes: Consequences of a Greek Exit, 11 February 2015.
3 ECB January data on monetary aggregates and balance sheets, 26 February 2015.
4 https://www.ecb.europa.eu/pub/pdf/other/art1_mb201402en_pp77-96en.pdf, page 82.
5 US Bureau of Labor statistics.