JP Morgan Private Bank's César Pérez, EMEA Chief Investment Strategist, reviews the current economic environment in Europe in comparison to four years ago when market confidence in the Euro area was at breaking point.
JP Morgan Private Bank’s César Pérez, EMEA Chief Investment Strategist, reviews the current economic environment in Europe in comparison to four years ago when market confidence in the Euro area was at breaking point.
Almost four years ago this summer, the European crisis was at its crux. The fiscal imbalances of periphery countries led the markets to doubt their economic and monetary sustainability. Between 2010 and 2011, Greece, Ireland and Portugal required financial assistance and as a result entered into economic adjustment programmes with the EU and IMF. While Spain and Italy avoided full-scale programmes, they also embarked on a journey of fiscal and structural reform that is still on-going.
Where are we now?
Last year marked the Eurozone’s exit from the sovereign debt crisis. Economic data started improving from cycle lows, partly as a result of structural adjustments undertaken by periphery countries. Markets trust the ECB’s OMT programme will function as a backstop. Equity markets rallied and fixed income spreads tightened as a result of improved funding markets for banks and sovereigns. All periphery countries apart from Greece now have 10-year yields under 5%.
Some important pending issues remain: banks are not eager to lend to the real economy and domestic consumption is still weak. There are still sources of systemic instability in the region, as the Cypriot crisis proved last year. With every round of elections, regardless of the country in question, radical parties cloud the horizon. However, the positives outweigh the negatives. We believe the recovery is well underway in the periphery, and the markets trust the ECB to provide a safety net in the event of disruption. These regional developments, together with an improved global economic outlook, lead us to forecast real GDP growth of around +1% – 1.5% for 2014. Europe is slowly emerging from recession.
We believe 2014 will be the year when rating agencies will reverse their downgrade trend for developed markets and, more specifically, for periphery countries that are already signalling a return to normality.
After a series of painful fiscal adjustments and structural reforms, Ireland was the first country in the periphery to exit the bailout programme. It has the market’s confidence to support its slow way out of the crisis. Deleveraging still needs to take place in both the private and public sector, and as a consequence banks will need further capital support. Overall, however, the country’s economics have improved. Given the current stabilising cycle, its return to the market later this year or in 2015 looks feasible.
There is positive growth momentum in Spain. Financing conditions remain difficult for SMEs but have improved for large parts of the economy, including banks. Exports have represented the bulk of Spain’s GDP recovery, and global growth will therefore be one of the main factors for the country’s continued growth. While internal deleveraging takes place, the country remains very sensitive to global economy developments and is especially vulnerable to an EM slowdown.
Italy’s government has kept its attention on public finances and managed to contain its increasing debt-to-GDP. Renzi needs domestic support in order to keep a stable government and create the necessary environment for further reforms. More needs to be done to reform business conditions and the judicial system. Change in the electoral law is key to showing there is enough goodwill to pursue change. Without the implementation of structural reforms, the recovery will remain weak.
We believe the increased market access and potential programme exit in 2014 are positives for Portugal. As in Spain, the risks to the ongoing recovery are the fiscal adjustments needed to reduce the high public and private debt. The government needs to continue structural reforms in order to be able to negotiate some form of OSI deal with the EU, which could take the form of debt interest relief or maturity extensions. Portugal can also exit the programmes gradually by tapping into a precautionary credit line.
The next step in the Greek recovery is having these economic changes feed into the social fabric. Unemployment is still at a record level of around 28%. Stabilisation of the job market would help support the other developments taking place in the economy. Most importantly, Greece is not under impending pressure to look for funding in the markets and will only raise funds if it feels it is a positive enough signal for sentiment. European and Greek local elections in May will be a checkpoint for the progress of current policies. We expect headline instability later in the year, with volatile peripheral spreads as a consequence. Sentiment is better now in Greece than it was before the PSI restructuring in March 2012, and that many of the tough reforms and adjustments have already been made. The ultimate decision on Greece’s progress and future remains in the hands of the Greek people, expressed through electoral platforms.
Four years after their bailout rescues, periphery countries have falling deficits and lower government financing costs. Unemployment rates are higher than the Euro area average, however, and growth is differentiated across the economy. The disinflationary trend in the periphery is also a risk to the recovery, should it persist in the medium term.
Supply and demand dynamics indicate that periphery countries have had the goodwill of the markets since Europe became investable again in mid-2012. What we need to see on the monetary side is interest rates for companies in the periphery converging towards levels in the core countries. On the economic and social side, we believe a decline in unemployment will be the major progress indicator. For the medium-term success of a sustainable recovery, we need to see political stability across the Euro area and continued implantation of structural reforms across various sectors of the economy. Several measures of debt relief have given the periphery countries time: loans are not due for repayment for at least three years.
Over the long term, the ECB will continue to actively keep yields low at the short and long end. In our portfolios, despite being underweight in government bonds and tilted towards short durations, we prefer European rates, especially the sovereign medium-term bonds of Italy and Spain. For equities, operational gearing should allow European companies to generate strong returns as their operating margins improve from a very low base. As European equity valuation multiples have run in 2013, depressed margins show there is still room for improvement, while operating leverage will contribute positively to returns. Our model for MSCI EMU shows that a projected Euro area growth rate of 1.4% oya should translate into Eurozone EPS growth of around 8%. A dividend yield of around 3.4% would push potential total returns into the low double digits.
We are currently actively managing these existing equity and fixed income investment opportunities in our portfolios. However, for the longer term, we keep in mind that the Euro area’s structural journey is not yet finished. The periphery has won many battles so far, some on the political front and others on the institutional reform front. An important step towards winning the war will be the revival of employment and domestic demand. This is when we will be ready to call the European recovery a success.