Tag: europe

Existential Crisis in Europe: Through the Lens of Healthcare

 

“Like Hitler, like Stalin, the énarque believes that power will always prevail over economics.” ― Bernard Connolly, The Rotten Heart of Europe: Dirty War for Europe’s Money

“Everybody aspires to an affordable home, a secure job, better living standards, reliable healthcare and a decent pension. My generation took those things for granted, and so should future generations.” ― Jeremy Corbyn

 

Señor Mario Draghi pledged in 2012 to do “whatever it takes” to save Europe from the sovereign debt crisis that engulfed many members of the European Union. Those momentous words took the eurozone out of the throes of a crisis and put into motion an epic collapse in bonds yields in Europe first, the rest of the developed world second.

 

Mario Draghi’s resolve brought about an immediate shift in the market’s mood. Traders reacted with alarming speed, jumping into European sovereign bonds, reaping huge rewards as yields collapsed across the Eurozone. Mario Draghi understood well the importance of psychology on market participants when he stepped up to avert the EU’s existential crisis.

 

Today, the European Union faces a different kind of existential crisis. One brought on by healthcare systems in Italy, Spain and other parts of Europe bursting at the seams, unable to provide the necessary care to contain the suffering of those afflicted with the coronavirus.

The physical world is defined by constraints. Neither words nor policy can be used to conjure up more hospital beds, deliver vaccines or transform able citizens into frontline healthcare professionals. Yes, war time like measures can be taken to divert productive resources away from the expendable to the essential, even such measures, however, require time, energy and a requisite set of skills and resources.

Words are unlikely to suffice this time around.

 

Europe Divided

 

“Italy’s political leaders from Left to Right have erupted in fury over the EU’s minimalist, insulting, and cack-handed response to the Covid-19 pandemic, warning that lack of economic solidarity risks pushing the bloc’s festering divisions beyond the point of no return.” ― Ambrose Evans-Pritchard, EU project in ‘mortal danger’ if Italy and Spain are abandoned

 

Jean Monnet, one of the founding fathers of the European Union, famously argued that “Europe will be forged in crises, and will be the sum of the solutions adopted in those crises.”

The COVID-19 pandemic has revealed the fragility of the bond that holds the EU together. In a matter of weeks, the EU has gone from a single bloc to each member fending for themselves in a bid to contain the damage wrought by the pandemic.

France, Italy, Spain and six other members of the EU, in a joint letter to European Council president Charles Michel, have called for the issuance of ‘coronabonds’ — that is, joint European debt to finance the fight against coronavirus. Germany and the Netherlands, in response, have expressed reservations and are ruling out any such issuance.

The Europe Union has not put forth a solution to the current crises, will the consequence be a continent divided?

 

Currency Straitjacket

 

EU membership comes with many constraints. Particularly onerous are the budgetary limitations placed on those economies unable to live within their means or suffering from an economic slowdown. Further exacerbating the issue is the common currency, which has eliminated the flexibility to depreciate previously availed by the economic laggards remain competitive.

Take for instance, the ratio of the purchasing power parity (PPP) based exchange rates for Germany and Italy. (In the chart below, a downward sloping line implies a depreciation of Italy’s exchange rate relative to Germany’s exchange rate in PPP terms.)

PPP Germany Italy

During the 1990’s, the Italian lira almost consistently depreciated relative to the deutschemark. This process of continuous depreciation enabled the Italian economy to compete with the German economy, if not in terms of sophistication, most definitely in terms of price. Since the introduction of the euro, however, Italy has lost this flexibility and can improve upon the German offering neither in price nor in sophistication.

This lack of flexibility combined with the budgetary and fiscal constraints that come with EU membership, is unlikely to escape the scrutiny of the Italians and their Mediterranean neighbours. Especially as they come to weigh the costs of EU membership in shadow of the suffering of their citizenry during the COVID-19 pandemic. The evidence is particularly damning, when one considers how these constrictions have translated into systematic underinvestment in the healthcare systems of countries that have lagged behind economically.

 

Healthcare Expenditure

 

The chart below compares healthcare expenditure, as a share of total government expenditure for Germany, Italy and Spain.

Healthcare Exp pct

Healthcare spending, relative to other forms of government spending, in Germany has increased by almost 2 percentage points between 2010 and 2019. Whereas it has declined by 1 percentage point in Italy and remained about the same in Spain.

In both absolute and relative terms, this has translated into a significant increase in the amount Germany spends on healthcare. In 2010, Germany spent, in current euro terms, approximately €60 billion more than Italy on healthcare. In 2019, the difference in healthcare expenditure between the two nations amounted to more than €120 billion. In per capita terms, Germany spent 9.2 per cent more than Italy on healthcare in 2010; in 2019, the difference was 46.3 per cent.

Given its robust economic performance, Germany, within the confines of the EU’s rules, has been able to substantially increase its government expenditures. Whereas, Italy and Spain, in the aftermath of the sovereign debt crisis, have been unable to increase overall government expenditure. The unfortunate corollary of which is a stagnation of investment in their respective healthcare systems.

Healthcare Exp abs

The growing disparity in healthcare investment across the EU is even more stark when comparing the availability of hospital beds. In 1995, Italy had 6.3 beds per 1,000 people, Spain 3.9 and Germany 9.7. At the end of 2017, Italy was down to 3.2 beds per 1,000 people, Spain 3.0 and Germany 8.0.

hospital beds

Italian and Spanish hospital bed capacity per capita has declined by half and one third, respectively, even as their populations have aged and the need for healthcare services has increased not decreased.

 

A New Way Forward

 

Whether it is German conservatism, Mediterranean profligacy or a combination of both that has contributed to the woeful under investment in healthcare in Spain and Italy, we do not know for certain. We do, however, see the statistics as a powder keg that could bring about the end of EU in its current form.

For the populace may withstand economic hardship in pursuit of a lofty goal; there are few, however, that will accept the suffering or loss of loved ones. If they are not already, it is only a matter of time before Italians and Spaniards begin questioning why they given up sovereignty over their laws, their borders, their budget and their currency, when in their time of need their membership in the EU has hindered, not supported, them.

From Arundhati Roy in the Financial Times:

 

“Historically, pandemics have forced humans to break with the past and imagine their world anew. This one is no different. It is a portal, a gateway between one world and the next.

We can choose to walk through it, dragging the carcasses of our prejudice and hatred, our avarice, our data banks and dead ideas, our dead rivers and smoky skies behind us. Or we can walk through lightly, with little luggage, ready to imagine another world. And ready to fight for it.”

 

The European experiment, once these trying times pass, may ultimately hinge upon which nation chooses to walk into the future lightly. Will it be one of Italy, Spain or any one of the other member nations suffering under the weight of the euro, choosing to leave behind the currency? Or will Germany overcome the scars of her past and shed its fiscal conservatism?

Time will tell. For now, we believe the Europe of tomorrow, will be unlike the Europe of yesterday.

 

Stay safe.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

A Mix of Macro Charts

“The Federal Reserve has an official commitment to two different policies. One is to prevent inflation from getting too high. The second is to maintain high employment… the European Central Bank has only the first. It has no commitment to keep employment up.” ― Noam Chomsky

 

“A small group of people, they raise the price of oil and the whole world will suffer from this.” ― Ahmed Zaki Yamani, minister in OPEC for 25 years

A Mix of Macro Charts

In this week’s piece we share three macro charts that we hope will provide readers with an insight on how various risks are priced in markets by a seeming disparate range of instruments and indicators.

Short-Term Rates and the Yield Curve

YC 3m bills

The above chart is of the de-trended 3-month Treasury bill rate (inverted) ― de-trended by subtracting the 10-year moving average from the bill rate ― versus the US Treasury 10-year and 3-month yield curve. The chart dates from 1962 till today, suggesting that the de-trended 3-month Treasury bill rate contains information about the direction of the yield curve.

The two-time series have a correlation of -0.77 with an r-squared of 59 per cent.

(The dashed lines on the above chart are the average de-trended bill rate and levels one standard deviation above and below the average.)

The relation between the de-trended bill rate and the yield curve indicates a strong tendency of interest rates to mean revert. The wider the gap between the current de-trended bill rate and its long-term average, the stronger the markets expectation of mean-reversion. For example, the de-trended bill rate being one standard deviation above (below) its average generally serves as a guide post to position for a yield curve steepening (flattening / inversion). (The time series is inverted, so above the average means visually below on the chart.)

The de-trended bill rate recently reached one standard deviation above its long-term average and has since turned down, suggesting that fixed income investors position for a yield curve steepening, as opposed to a direct long or short position at either end of the curve.

 

Equity market investors can play a steepening yield curve by being long financials.

 

The Golden Period of Risk-Parity and 60/40 Allocations

stock bond correl

The above chart is the 6-month rolling US stocks-to-bond correlation and the 6-month rolling average of the annual rate of inflation, as measured by the consumer price index.

The relationship demonstrates (1) how the capital markets price in inflation and (2) the correlation between stocks and bonds is not static. The implication of the latter is that bond allocations do not always serve as a suitable diversifier for equity allocations. Rather, it is the prevailing market regime that determines the efficacy of bond allocations to lower draw downs and portfolio level volatility during equity market sell-offs.

Capital markets price in inflation ― outside financial crises when the safe haven demand for bonds can overwhelm implicit inflation expectations ― through an adjustment of the correlation between stocks and bonds. During the period from 1965 through to 1997, when inflation expectations experienced large swings, the stock-to-bond correlation was almost consistently positive. That is, changes in inflation expectations drove both stock and bond returns and during periods of equity market weakness bond allocations did not make up the difference. For example, in the sub-period between 1973 and 1981, during which there was a negative supply shock from the OPEC oil export embargo, multiple recessions, high unemployment rates and high inflation, equity market weakness coincided with a poor bond market performance.

To re-iterate the point again, it is market regime that determines whether Treasury bonds are a “wonderful hedge” or a “terrible investment”. Moreover, we can from the chart above why the last decade and a half has been a golden period for risky parity strategies and 60/40 allocations ― stock-to-bond correlations have been and remained at or close to 100-year lows.

The question then is, how does one determine market regime?

Market regime is just another way of saying inflation expectations. Rising inflation expectations equate to rising stock-to-bond correlations. Retreating inflation expectations translate to declining stock-to-bond correlations. By extension, something touched upon last week, the combination of stable, that is expectations of more of the same, and low-levels of inflation makes for the optimal investment environment.

Continuing to bet on more of the same when stock-to-bond correlations have been at 100-year lows for a prolonged period is surely asking for trouble. All the more, with political movements the world over nudging the global economy from being driven by negative and positive demands shocks to becoming one that will be driven by positive and negative supply shocks, a market regime change seems inevitable.

 

Demand shocks, either positive or negative, do not move the Phillips curve; supply shocks, however, shift it in and out. When the Phillips curve shifts in response to a negative supply shock, nominal bonds exacerbate losses suffered in equity markets. For example, an adverse supply shock in the form of the oil embargo by the OPEC in 1973 shifted the Phillips curve by increasing both production and distribution costs of almost all industries and led to losses for both equity and bond market investors.

 

That is why we think investors need to consider instruments other than bonds to hedge equity allocations. The Japanese yen, precious metals, Treasury Inflation-Protected Securities (TIPS), oil and energy stocks are some of the viable options. It is likely that there are others.

 

Why do we keep insisting on oil and energy stocks? Well because oil is the most obvious negative supply shock we can conceive of in the event of an Elizabeth Warren or Bernie Sanders presidency. Both Democratic presidential contenders have proposed to ban fracking altogether.

 

Europe Sovereign Risk Model

euro sov risk.png

The above chart is the ratio of gold, in euros, to the Euro Area all shares index versus the differential between 10-year government bond yields of the ‘fragile’ European economies and Germany. (For the latter we use the average of the yields on Spanish, Portuguese and Italian 10-year bonds and subtract from it the yield on 10-year German bonds.)

The two series are a means of measuring sovereign, or break up, risk in Europe. Rising ratios imply rising sovereign risks and a rush towards the safe havens of gold and German debt. Recently, with gold having rallied and some form of Brexit related agreement forming, the two time series have diverged. The yield differentials indicate a declining risk premium while the gold-to-shares ratio indicates a rising risk premium.

We think the two series should start to converge with European stock markets continuing to head higher.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Will Europe be the Fall Guy in the Trade Deal?

 

“Capable, generous men do not create victims, they nurture victims.”  — Julian Assange

 

“Politics is tricky; it cuts both ways. Every time you make a choice, it has unintended consequences.”  — Stone Gossard, lead guitarist for Pearl Jam and member of the Rock and Roll Hall of Fame

 

A slightly shorter piece than usual this week as we recover from  jet lag following a ten day trip to the US. This week we discuss, the potential fallout from a US-China trade deal.

 

 

In 1978 China accounted for less than one hundredth of global trade. By the turn of the millennium, its share had increased threefold. In a decade’s time, by 2010, its share of global trade had tripled again and in 2013 China surpassed the United States, becoming the world’s largest overall trading nation.

 

As China’s share of global trade has increased so too has the number of trade disputes it has been involved in. Between 2006 and 2015, China was party to, as either complainant or respondent, in more than a quarter of the trade dispute cases lodged with the World Trade Organisation (WTO).

 

Notably, according to Harvard Law Professor Mark Wu, there has been a notable shift in the “pattern of WTO cases among the major trading economies — the United States, European Union, Japan, and China”. Up until the global financial crisis, the US, Japan and the European Union would regularly file complaints against one another. Following the crisis, however, only three cases have been brought by the three major developed economies against one another. Instead, the cases brought by the major powers have almost exclusively been focused on China — 90 per cent of the cases they brought to the WTO between 2009 and 2015 were China-related.

 

The meteoric rise of the Chinese economy and its growing influence on global trade has challenged the pretext under which the WTO was formed. The WTO has struggled to adapt and to develop an equitable dispute settlement system to counter China’s, at times, egregious trade practices. The WTO cannot, given China’s importance to global trade, make rulings or draft new rules that China sees as discriminatory or unfair but at the same time it cannot seen to be a lame duck and see other member countries turn away from it. The inability to effectively settle this dilemma has weakened the institution’s credibility.  So much so that the WTO Appellate Body no longer has enough members to hear all possible cases — the US has vetoed all appointments to the body. Many see the US vetoes as a death knell for the WTO — signalling a return to  a world where trade disputes are settled through bilateral negotiations and the WTO’s dispute settlement system is defunct.

 

The United States Trade Representative, Robert E. Lighthizer, has, since taking office in May 2017, pursued a campaign against China based on the statutes of Section 301 of the 1974 Trade Act, which allows unilateral action by the US President against trade policies deemed unfair. In effect, the US Trade Representative’s strategy sidelines the WTO.

 

The Trump Administration’s approach of using Section 301 has been seen, by many, as both aggressive and likely to lead to negative consequences for the Chinese economy.  What if, however, President Trump has come to the realisation, that also afflicted his predecessors, that the American and Chinese economies are too closely intertwined for either side to be a victor in a trade war? If so, we wonder, is Europe going to be the fall guy in the trade deal?

 

Europe’s Trade Surplus with the US

 

From the Wall Street Journal:

 

The European Union reported a record trade surplus with the U.S. last year, a development that could weigh on slow-moving U.S.-EU trade talks and comes as the Trump administration prepares to deliberate hefty tariffs on European car imports.

Meanwhile, slowing exports from Europe to other trading partners, most notably China, in 2018 suggest the flagging EU economy could cool further this year. Failure of the U.S.-EU trade talks and fresh duties from the U.S. could compound Europe’s economic pain in 2019.

 

President Trump, we suspect, is going to look for an alternative win should the trade dispute with China be resolved amicably. We suspect, Europe, with its record bilateral trade surplus, is likely to find itself in the line of fire. For it was only days before Trump’s visit to Europe last year that President Macron called for the creation of a “true European army” and agitating the US President in the process.  Moreover, Europe is in a mess —  with the small matter of Britain’s exit from Europe imminent and a leadership vacuum with Angela Merkel a lame duck in office, Emmanuel Macron too occupied trying to contain the yellow vest movement, Italy moving from one crisis to another — meaning there is little hope for a coordinated response from the trade bloc, should President Trump throw down the gauntlet.

 

With any resolution of the US-China trade dispute likely to come with conditions for China to increase purchases of US goods and services, China is likely to reduce purchases of European goods and services in response. This is will only compound Europe’s problem further.

 

We think there is little reason to be overweight, or even equal weight, European equities at present.

 

Extending the same line of thinking, we think China is likely to increase its purchases of agricultural commodities from the US by reducing purchases from Brazil. For emerging markets exposure, we would underweight Brazil.

 

Semiconductor Leadership

 

 

Were the above tweets a wink to the national security hawks in the Trump Administration to end the pursuit of Huawei and stop placing export controls on US semiconductors producers?

 

If so, we think $SOXX should continue to be amongst the leaders in the US market. If, however, if there is sudden weakness in the semiconductor space we would be concerned about the prospects of an amicable trade resolution.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

 

 

 

Two Investment Ideas

 

“Since the earliest days of our youth, we have been conditioned to accept that the direction of the herd, and authority anywhere — is always right.” – Rise Up and Salute the Sun: The Writings of Suzy Kassem by Suzy Kassem

 

“My life seemed to be a series of events and accidents. Yet when I look back, I see a pattern.” – Benoît B. Mandelbrot

 

 

In this week’s piece we identify two investment ideas: cloud-based enterprise software companies and European banks. The former has caught our attention through its recent show of strength and the latter for its recurring weakness.

 

Cloud-Based Enterprise Software

 

A number of cloud-based, software-as-a-service (SaaS) companies have been out performing markets since the US equity market started to sell-off in October last year.

 

Volatile Period: 4 Oct, 2018 – 11 Jan, 2019

  Total Return
S&P 500 Index -10.74%
Veeva Systems -5.49%
Workday Inc. +14.97%
Salesforce.com -7.26%
Benefitfocus Inc. +32.01%
Intuit Inc. -10.48%

 

Sell-Off: 4 Oct – 24 Dec, 2018

Despite being higher beta tech-stocks, some of the SaaS names have fared far better than the S&P 500 Index during the sell-off between October and Xmas, whiles others largely matched the market’s performance.

  Total Return
S&P 500 Index -19.25%
Veeva Systems -23.36%
Workday Inc. -2.23%
Salesforce.com -23.74%
Benefitfocus Inc. +13.18%
Intuit Inc. -20.83%

 

Rally Off-the-Lows: 26 Dec 2018 – 11 Jan, 2019

On the other had, in the rally off-the-lows all of the SaaS stocks we identify have significantly outpaced the market.

  Total Return
S&P 500 Index +10.54%
Veeva Systems +23.32%
Workday Inc. +17.59%
Salesforce.com +21.61%
Benefitfocus Inc. +16.63%
Intuit Inc. +13.07%

 

In each of the charts presented below, there are two panels – the top one showing the price performance of each stock and the bottom one showing the performance of the stock relative to the S&P 500 Index. A number of the stocks are witnessing their respective relative performance break to new highs.

 

Veeva Systems   $VEEV

(This is not the first time we are discussing $VEEV, our previous comments on the stock can be found here.)

$VEEV, founded in 2007, is the leading customer relationship management (CRM) solutions provider to the life sciences industry. The company was founded by and is managed by a highly experienced management team with both software and life sciences experience.

The company delivers its services through cloud-based architecture and its core CRM products, representing close to nine-tenths of revenue, are built upon Salesforce.com’s force.com platform.

 

Veev

 

$VEEV counts over two-thirds of the 50 leading global pharmaceutical companies amongst its clients. Its products enable pharmaceutical and life sciences companies to manage customer databases, track drug developments, and organise clinical trials with industry-specific functionality and maintaining regulatory compliance.

Multinational companies’ growing preference for cloud-based solutions has been and continues to be a secular tailwind for $VEEV. Specialised cloud-based solution providers, we think, are well-placed to continue grabbing market share from on-premise incumbents, such as SAP and Oracle, that have been slow in adapting to their clients’ shifting preferences.

$VEEV having established a beachhead with its core CRM products has over the years launched complimentary products that are supporting sales growth.

  • 2011: Introduced Vault, a document management product, which quickly gained traction with existing clients including at least six out of the top 20 global pharma companies.
  • 2013: Launched Network, product that provides critical customer information that can easily be integrated with its other solutions.
  • 2018: Unveiled Nitro, a  ready-to-use commercial data warehouse in the cloud tailored  for the needs of the life sciences industry that comes with a packaged software solution. The company has already signed up four customers for the product since its launch.

The newer solutions, unlike the core CRM products, are based on the company’s proprietary platform and not force.com.

 

Workday Inc.   $WDAY

$WDAY is a cloud-based financial and human capital management software solutions provider. Amongst the enterprise software companies, $WDAY has one of the largest established and addressable markets. It already counts 35 per cent of the Fortune 500 companies as clients for its human capital management solutions and its financial management solutions are also gaining traction.

WDAY

$WDAY has been extending its international presence and product offering, in a bid to  grab market share from incumbents SAP and Oracle.

The company’s products, ranking at the highest levels in independent customer satisfaction surveys, are regarded by many industry experts to have the potential sustain strong sales growth at scale for many years to come.

 

Benefitfocus Inc.  $BNFT

We added to $BNFT to our trade ideas on 3 December, 2018.

BNFT

 

Salesforce.com   $CRM

$CRM, with its iconic 1,070-foot tower in the South of Market district of downtown San Francisco, is of course one of the pioneers of cloud-computing and amongst the very elite tech companies in the world.

CRM

 

Intuit Inc.   $INTU

$INTU develops and markets business and financial management software solutions for small and medium sized businesses, financial institutions, consumers, and accounting professionals. It is one the highest quality enterprise software franchises in the US market.

 

Intu

 

Our preferred picks amongst the above names are $VEEV, $WDAY and $BNFT.  We are neutral to positive on $CRM and neutral on $INTU. We would look to buy our preferred names on any pullbacks. Moreover, for the brave amongst you,  SAP $SAP.GY and Oracle $ORCL can be shorted on rallies.

 

European Banks

From the Financial Times:

“Representation has splintered in almost every sizeable political system in Europe, making it harder to form governing coalitions, creating political instability and giving a voice to new formations on the radical left and right and in the political centre.”

Add “splintered representation” to the growing list of crises, existential or otherwise, European Union has had to deal with since the Global Financial Crisis.

Greece.

Cyprus.

Other periphery states’ debt crises.

Brexit.

Mouvement des gilets jaunes.

Italy’s populist coalition.

Spain’s Banco Popular.

Italy’s Banca Monte dei Paschi di Siena.

Deutsche Bank.

 

Given the long-list of challenges faced by Europe, it may seem strange that we are identifying European banks as an investment opportunity. However, one look at the chart of the European banking index below should explain why.

 

Euro Banks

 

Ever since the Global Financial Crisis, whenever European banks have fallen to the levels they are currently trading at, the ECB has come out with a statement or a policy to shore up investor confidence.

Given the ECB’s track record, we think being long European banks at current levels has an attractive risk-reward profile. Nonetheless, given the uncertainty surrounding Europe, we think a pair trade involving long European banks and short the STOXX Europe 600 Index might be a prudent way to express the view.

  • If the ECB comes out with a favourable policy announcement and all European stocks rally, European banks, we think, will out perform the broader European stock indices.
  • Alternatively, if the ECB does nothing and things continue to deteriorate, even though banks would probably go down, they are likely to out perform the broader equity market given that they are already at 10-year lows and the average European stock is not.

An alternative expression of the trade could be to be long EURUSD.

Euro Banks EURUSD

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

US vs. Europe: A Closer Look at US Outperformance

 “Europe was created by history. America was created by philosophy.” – Margaret Thatcher

“In America everything goes and nothing matters, while in Europe nothing goes and everything matters.” – Philip Roth, American novelist and modern literary great

MSCI Europe Index vs. S&P 500 Index – Total Return in USD Indices TRSource: Bloomberg

In the ten years since the global financial crisis, European stocks have underperformed US stocks by a considerable margin.

In the first three years following the global financial crisis, the performance of the two markets were not too dissimilar. For the period commencing end of November 2008 through October 2011, the MSCI Europe and S&P 500 indices generated total returns of 46 and 53 per cent in US dollar terms, respectively.

Since late 2011, however, investors in European stocks have been left frustrated all the while investors in US stocks have enjoyed a long-running bull market. From 29 October 2011 through 20 November 2018, the MSCI Europe Index has generated a total return of 35.8 per cent in US dollar terms – 102.8 per cent less than the total return of the S&P 500 Index for the same period.

Despite, the strong outperformance of US equity markets relative to European equity markets, European stocks have been more expensive, on a trailing 12 month price-to-earnings basis, for the majority of the time since late 2011. Only since late 2017 have European equities become cheaper than US equities on a trailing 12 month price-to-earnings basis.

MSCI Europe vs. S&P500: Trailing 12 Month Price-to-Earnings RatioIndices PESource: Bloomberg

At an index level and since the global financial crisis, US companies have grown revenues and earnings at a faster clip than their European companies.

MSCI Europe vs. S&P500: Revenue Growth RevenueSource: Bloomberg

MSCI Europe vs. S&P500: Earnings Growth EarningsSource: Bloomberg

In terms of annual performance, European markets have outperformed US markets in three out of the nine calendar years since the global financial crisis: 2009, 2012, and 2017. Notably, in 2009 and 2017, European companies’ year-over-year earnings growth rates were far superior to those of American companies. While outperformance in 2012, can be attributed to Signor Draghi uttering those famous words that brought Europe back from the brink: “Whatever it takes”.

European earnings also outpaced US earnings during the years 2010 and 2013, yet US stocks outperformed European stocks. The year 2010 was, of course, when the sovereign debt crisis engulfed the peripheral members – Portugal, Italy, Ireland, Greece and Spain – of the European Monetary Union. While in 2013, although European equities underperformed US equities , it was still a very good year for Europe with the MSCI Europe Index generating a total return of around 23 per cent in US dollar terms versus around 28 per cent for the S&P 500 Index.

Digging a little deeper we compare the performance between US and European markets on a sector-by-sector basis, using the Global Investment Classification Standards (GICS) level 1 classifications.

US vs. Europe: 5- and 10-Year Sector Level Total Returns (USD) Sectors TR

Source: Bloomberg

Note: Periods ending 31 Oct 2018, calculated using monthly data, and excludes real estate

For both the 5- and 10-year periods for every sector except energy, US performance has been superior to European performance – we have excluded real estate as we were unable to gather clean data for the sector.

The US energy sector has lagged the European energy sector largely due to the much higher number of listed shale oil companies in the US. Shale oil plays witnessed significantly larger drawdowns as compared to blue chip oil producers following the sharp drop in oil prices in late 2014.

For the 10-year period ended 31 October 2018, the greatest difference in performance between the two markets comes from the consumer discretionary and information technology sectors. The consumer discretionary sector includes Amazon and used to include Netflix – a significant portion of US consumer discretionary outperformance can be attributed to Amazon and Netflix. While the outperformance of the American information technology sector has been broader than that of the consumer discretionary sector, a handful of stocks still have had an outsized impact on US outperformance. These stocks are namely Apple, Google, Facebook, Salesforce.com, Microsoft and Nvidia. (Note: In January 2018 the industry classification of Google, Facebook, and Netflix was changed to communication services).

The most comparable performance between the two markets, for the 10-year period, comes from the energy, materials, consumer staples and industrial sectors.

US vs. Europe: 5-Year Sector Level Revenue and Earnings Growth Sectors Rev Earnings

Source: Bloomberg

The above table details the 5 year (4-years for communication services) revenue and earnings growth by sector for US and European stocks.

Notably, in the US, net margins expanded from 2012 through 2017 across all sectors except energy. While in Europe, margins expanded for six sectors and declined for three – margins declined for the consumer discretionary, utilities and communication services sectors.

Median sector level revenue growth in the US for the five-year period was 20.96 per cent versus -2.26 per cent in Europe. (Earnings level comparisons are not meaningful in our opinion due to the artificially high earnings growth in certain sectors in Europe due to write-downs / exceptional circumstances in 2012 that understate earnings at the beginning of the period.)

Investment Perspective

The underperformance of European equities relative to US equities over the last five- and ten-years can predominantly be explained by fundamental factors. The challenge at this juncture, however, becomes that of identifying scenarios under which European stocks would arrest this trend of underperformance and begin outperforming the US stocks on a prolonged basis. We outline three such scenarios below.

  1. If the next ten years are not like the last ten years

If we assume, simplistically and without trying to predict how, that the next ten years will be unlike the last ten years then there should be a preference for non-US stocks over US stocks in general.

In capital markets dominated by passive allocations to market capitalisation weighted indices, the main drawback is that the allocation to ‘go-go’ stocks is at its highest when they are at their peak relative to other stocks in the indices.

With respect to the S&P 500 Index, the information technology, healthcare, financials, communication services and consumer discretionary sectors have gone from representing 58 per cent of the index at the start of 2009 to almost 70 per cent today. And within these sectors the increase in allocation to technology and technology related stocks has been even more pronounced.

S&P 500 Index Allocation by GICS Level 1SPXSource: Bloomberg

The change in sector allocation for US indices has been far more prominent than it has been for European indices – simply because the dispersion in performance between sectors has been much greater in the US. Over the last ten-years the top performing sector in the S&P 500 Index has outperformed the median sector by almost 260 per cent. In comparison, the total return differential between the best performing and median sectors is 63 per cent for the MSCI Europe Index.

MSCI Europe Index Allocation by GICS Level 1 MSCIESource: Bloomberg

  1. Labour not capital is rewarded

“The defining characteristic of economics in the 1950s is that the country got rich by making the poor less poor.

Average wages doubled from 1940 to 1948, then doubled again by 1963.

And those gains focused on those who had been left behind for decades before. The gap between rich and poor narrowed by an extraordinary amount.”

– Excerpt from Morgan Housel’s piece How This All Happened:

In the aftermath of the global financial crisis, unemployment levels shot up across the world. The global economy has spent the last ten-years healing from the damage wrought by the financial crisis. Slack in the labour market has been slow to dissipate and wages have remained stubbornly stagnant.

The corollary of the abundance of labour has been capital owners benefiting at the expense of labour.

As the global economy has healed, unemployment levels have gradually declined and wage pressures have slowly emerged. The European labour market, however, has much more slack than the US labour market – where unemployment levels are reaching twenty year lows and wage pressures are much more significant.

If demand for labour picks up globally, Europe has much more room to reduce unemployment levels before wages have to pick up meaningfully. Whereas the US has limited, if any, room for unemployment levels to drop lower without a meaningful increase in wage inflation. Therefore, Europe has greater flexibility to facilitate an improvement in household earnings without it impacting profit margins.

  1. Capital investment / infrastructure spending pick ups

US corporations have been far savvier capital allocators than their transatlantic counterparts – they have reduced equity, through share buy backs, and increased leverage during a time when servicing debt has never been easier. The behaviour of US corporations has been facilitated not only by record low interest rates but also by a limited need for capital investment – a deflationary environment incentivises the postponement of capital investment.

If capital investment picks up globally – motivated by inflation, infrastructure development led diplomacy, such as China’s Belt and Road Initiative, or a need to reconfigure global supply chains due to trade wars – European indices, with their much greater weighting to the industrial and materials sectors, are better placed to outperform the more technology leaning US indices in such a scenario.

Moreover, increasing capital investment may spur demand for credit in Europe and support the much maligned European financial services sector, which also happens to be the sector with the highest allocation in the MSCI Europe Index.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Don’t wait for the US Dollar Rally, its Already Happened

 

“Don’t cry because it’s over. Smile because it happened.” – Dr Seuss

 

“Republicans are for both the man and the dollar, but in case of conflict the man before the dollar.” – Abraham Lincoln

 

“Dark economic clouds are dissipating into an emerging blue sky of opportunity.” – Rick Perry

 

According to the minutes of the Fed’s June meeting, released on Thursday, some companies indicated they had already “scaled back or postponed” plans for capital spending due to “uncertainty over trade policy”. The minutes added: “Contacts in the steel and aluminum industries expected higher prices as a result of the tariffs on these products but had not planned any new investments to increase capacity. Conditions in the agricultural sector reportedly improved somewhat, but contacts were concerned about the effect of potentially higher tariffs on their exports.”

Despite the concerns around tariffs, the minutes also revealed that the Fed remained committed to its policy of gradual rate hikes and raising the fed funds rate to its long-run estimate (or even higher): “Participants generally judged that…it would likely to be appropriate to continue gradually raising the target rate for the federal-funds rate to a setting that was at or somewhat above their estimates of its longer-run level by 2019 or 2020”.

The somewhat hawkish monetary policy stance of the Fed combined with (i) expectations of continued portfolio flows into the US due to the interest rate differentials between the US and non-US developed markets, (ii) fears of the Trump Administration’s trade policies causing an emerging markets crisis, and (iii) the somewhat esoteric risk of ‘dollar shortage’ have led many to conclude that the US dollar is headed higher, much higher.

Of all the arguments for the US dollar bull case we consider the portfolio flows into the US to be the most pertinent to the direction of the greenback.

According to analysis conducted by the Council of Foreign Relations (CFR) “all net foreign demand for ‘safe’ US assets from 1990 to 2014 came from the world’s central banks”. And that “For most of the past 25 years, net foreign demand for long-term U.S. debt securities has increased in line with the growth in global dollar reserves.”  What the CFR has described are quite simply the symptoms of the petrodollar system that has been in existence since 1974.

Cumulative US Current Account Deficit vs. Global Foreign Exchange Holdings1aSources: Council on Foreign Relations, International Monetary Fund, Bureau of Economic Analysis

 

In recent years, however, global US dollar reserves have declined – driven by the drop in the price of oil in late 2014 which forced the likes of Norges Bank, the Saudi Arabian Monetary Agency, and the Abu Dhabi Investment Authority to draw down on reserves to make up for the shortfall in state oil revenues – yet the portfolio flows into the US continued unabated.

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings and comparing it to the cumulative US Treasury securities issuance (net), it is evident that in recent years foreign central banks have been either unable or unwilling to finance the US external deficit.

Cumulative US Marketable Treasury Issuance (Net) vs. US Treasury Major Foreign Holdings1Sources: US Treasury, Securities Industry and Financial Markets Association

 

Instead, the US has been able to fund its external deficit through the sale of assets (such as Treasuries, corporate bonds and agency debt) to large, yield-starved institutional investors (mainly pension funds and life insurers) in Europe, Japan and other parts of Asia. The growing participation of foreign institutional investors can be seen through the growing gap between total foreign Treasury holdings versus the holdings of foreign central banks.

US Treasury Total Foreign Holdings vs. US Treasury Major Foreign Holdings2Source: US Treasury

 

Before going ahead and outlining our bearish US dollar thesis, we want to take a step back to understand how and why the US was able to finance its external deficit, particularly between 2015 and 2017, despite the absence of inflows from its traditional sources of funding and without a significant increase in its cost of financing. This understanding is the key to the framework that shapes our expectations for the US dollar going forward.

We start with Japan. In April 2013, the Bank of Japan (BoJ) unveiled a radical monetary stimulus package to inject approximately US dollars 1.4 trillion into the Japanese economy in less than two years. The aim of the massive burst of stimulus was to almost double the monetary base and to lift inflation expectations.

In October 2014, Governor Haruhiko Kuroda shocked financial markets once again by announcing that the BoJ would be increasing its monthly purchases of Japanese government bonds from yen 50 trillion to yen 80 trillion. And just for good measure the BoJ also decided to triple its monthly purchases of exchange traded funds (ETFs) and real estate investment trusts (REITs).

Staying true to form and unwilling to admit defeat in the fight for inflation the BoJ also went as far as introducing negative interest rates. Effective February 2016, the BoJ started charging 0.1 per cent on excess reserves.

Next, we turn to Europe. In June 2014, Señor Mario Draghi announced that the European Central Bank (ECB) had taken the decision to cut the interest rate on the deposit facility to -0.1 per cent. By March 2016, the ECB had cut its deposit facility rate three more times to take it to -0.4 per cent. In March 2015, the ECB also began purchasing euro 60 billion of bonds under quantitative easing. The bond purchases were increased to euro 80 billion in March 2016.

In response to the unconventional measures taken by the BoJ and the ECB, long-term interest rates in Japan and Europe proceeded to fall to historically low levels, which prompted Japanese and European purchases of foreign bonds to accelerate. It is estimated that from 2014 through 2017 Japanese and Eurozone institutional investors and financial institutions purchased approximately US dollar 2 trillion in foreign bonds (net). During the same period, selling of European fixed income by foreigners also picked up.

As the US dollar index ($DXY) is heavily skewed by movements in EURUSD and USDJPY, the outflows from Japan and Europe into the US were, in our opinion, the primary drivers of the US dollar rally that started in mid-2014.

US Dollar Index3Source: Bloomberg

 

In 2014 with Japanese and European outflows accelerating and oil prices still high, the US benefited from petrodollar, European and Japanese inflows simultaneously. These flows combined pushed US Treasury yields lower and the US dollar sharply higher. The strong flows into the US represented an untenable situation and something had to give – the global economy under the prevailing petrodollar system is simply not structured to withstand a strong US dollar and high oil prices concurrently. In this instance, with the ECB and BoJ staunchly committed to their unorthodox monetary policies, oil prices crashed and the petrodollar flows into the US quickly started to reverse.

Notably, the US dollar rally stalled and Treasury yields formed a local minimum soon after the drop in oil prices.

US 10-Year Treasury Yield4Source: Bloomberg

 

Next, we turn to China. On 11 August 2015, China, under pressure from the Chinese stock market turmoil that started in June 2015, declines in the euro and the Japanese yen exchange rates and a slowing economy, carried out the biggest devaluation of its currency in over two decades by fixing the yuan 1.9 per cent lower.  The Chinese move caught capital markets by surprise, sending commodity prices and global equity markets sharply lower and US government bonds higher.

In January 2016, China shocked capital markets once again by setting the official midpoint rate on the yuan 0.5 per cent weaker than the day before, which took the currency to its lowest since March 2011. The move in all likelihood was prompted by the US dollar 108 billion drop in Chinese reserves in December 2015 – the highest monthly drop on record.

In addition to China’s botched attempts of devaluing the yuan, Xi Jinping’s anti-corruption campaign also contributed to private capital fleeing from China and into the US and other so called safe havens.

China Estimated Capital Outflows5Source: Bloomberg

 

The late Walter Wriston, former CEO and Chairman of Citicorp, once said: “Capital goes where it is welcome and stays where it is well treated.” With the trifecta of negative interests in Europe and Japan, China’s botched devaluation effort and the uncertainty created by Brexit, capital became unwelcome in the very largest economies outside the US and fled to the relative safety of the US. And it is this unique combination, we think, that enabled the US to continue funding its external deficit from 2014 through 2017 without a meaningful rise in Treasury yields.

Moreover, in the absence of positive petrodollar flows, we suspect that were it not for the flight to safety driven by fears over China and Brexit, long-term Treasury yields could well have bottomed in early 2015.

 

Investment Perspective

 

  1. Foreign central banks show a higher propensity to buy US assets in a weakening US dollar environment

 

Using US Treasury data on major foreign holders of Treasury securities as a proxy for foreign central banks’ US Treasury holdings, we find that foreign central banks, outside of periods of high levels of economic uncertainty, have shown a higher propensity to buy US Treasury securities during phases of US dollar weakness as compared to during phases of US dollar strength.

Year-over-Year Change in Major Foreign Holdings of Treasury Securities and the US Trade Weighted Broad Dollar Index 6Sources: US Treasury, Bloomberg

 

The bias of foreign central banks, to prefer buying Treasury securities when the US dollar is weakening, is not a difficult one to accept. Nations, especially those with export oriented economies, do not want to see their currencies rise sharply against the US dollar as an appreciating currency reduces their relative competitiveness. Therefore, to limit any appreciation resulting from a declining US dollar, foreign central banks are likely to sell local currency assets to buy US dollar assets. However, in a rising US dollar environment, most foreign central banks also do not want a sharp depreciation of their currency as this could destabilise their local economies and prompt capital outflows. And as such, in a rising US dollar environment, foreign central banks are likely to prefer selling US dollar assets to purchase local currency assets.

 

  1. European and Japanese US treasury Holdings have started to decline

 

European and Japanese US Treasury Holding 7Source: US Treasury

 

The ECB has already scaled back monthly bond purchases to euro 30 billion and has outlined plans to end its massive stimulus program by the end of this year. While BoJ Governor Haruhiko Kuroda in a testimony to the Japanese parliament in April revealed that internal discussions were on going at the BoJ on how to begin to withdraw from its bond buying program.

In anticipation of these developments and the increased possibility of incurring losses on principal due to rising US inflation expectations, it is likely that European and Japanese institutional investors and financial institutions have scaled back purchases of US dollar assets and even started reducing their allocations to US fixed income.

 

  1. Positive correlation between US dollar and oil prices

 

One of the surprises thrown up by the markets this year is the increasingly positive correlation between the US dollar and the price of oil. While the correlation may prove to be fleeting, we think there have been two fundamental shifts in the oil and US dollar dynamic that should see higher oil prices supporting the US dollar, as opposed to the historical relationship of a strengthening US dollar pressuring oil prices.

The first shift is that with WTI prices north of US dollar 65 per barrel, the fiscal health of many of the oil exporting nations improves and some even begin to generate surpluses that they can recycle into US Treasury securities. And as oil prices move higher, a disproportionality higher amount of the proceeds from the sale of oil are likely to be recycled back into US assets. This dynamic appears to have played out to a degree during the first four months of the year with the US Treasury securities holdings of the likes of Saudi Arabia increasing. (It is not easy to track this accurately as a number of the oil exporting nations also use custodial accounts in other jurisdictions to make buy and sell their US Treasury holdings.)

WTI Crude vs. US Dollar Index8Source: Bloomberg

 

The second shift is that the US economy no longer has the same relationship it historically had with oil prices. The rise of shale oil means that higher oil prices now allow a number of US regions to grow quickly and drive US economic growth and job creation. Moreover, the US, on a net basis, spends much less on oil (as a percentage of GDP) than it has done historically. So while the consumers may take a hit from rising oil prices, barring a sharp move higher, the overall US economy is better positioned to handle (and possibly benefit from) gradually rising oil prices.

 

  1. As Trump has upped the trade war rhetoric, current account surpluses are being directed away from reserve accumulation

 

Nations, such as Taiwan and the People’s Republic of Korea, that run significant current account surpluses with the US have started to re-direct surpluses away from reserve accumulation (i.e. buying US assets) in fear of being designated as currency manipulators by the US Treasury. The surpluses are instead being funnelled into pension plans and other entitlement programs.

 

  1. To fund its twin deficits, the US will need a weaker dollar and higher oil prices

 

In recent years, the US current account deficit has ranged from between 2 and 3 per cent of GDP.

US Current Account Balance (% of GDP)9Source: Bloomberg

 

With the successful passing of the Trump tax plan by Congress in December, the US Treasury’s net revenues are estimated to decrease by US dollar 1.5 trillion over the next decade. While the increase in government expenditure agreed in the Bipartisan Budget Act in early February is expected to add a further US dollar 300 billion to the deficit over the next two years. The combined effects of these two packages, based on JP Morgan’s estimates, will result in an increase in the budget deficit from 3.4 per cent in 2017 to 5.4 per cent in 2019. This implies that the US Treasury will have to significantly boost security issuance.

Some of the increased security issuance will be mopped by US based institutional investors – especially if long-term yields continue to rise. US pension plans, in particular, have room to increase their bond allocations.

US Pension Fund Asset Allocation Evolution (2007 to 2017) 10Source: Willis Tower Watson

 

Despite the potential demand from US based institutional investors, the US will still require foreign participation in Treasury security auctions and markets to be able to funds its deficits. At a time when European and Japanese flows into US Treasuries are retreating, emerging market nations scrambling to support their currencies by selling US dollar assets is not a scenario conducive to the US attracting foreign capital to its markets. Especially if President Trump and his band of trade warriors keep upping the ante in a bid to level the playing field in global trade.

Our view is that, pre-mid-term election posturing aside, the Trump Administration wants a weaker dollar and higher oil prices so that the petrodollars keep flowing into US dollar assets to be able to follow through on the spending and tax cuts that form part of their ambitious stimulus packages. And we suspect that Mr Trump and his band of the not so merry men will look to talk down the US dollar post the mid-term elections.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Europe: A Domestic Recovery Story

“By hamstringing the ability of French governments to act in the interests of the French people – or, to put it more realistically, by giving them an excuse for not so acting – that embrace has destroyed political legitimacy in France. It has contributed to a contempt for democratic politics so profound, among both rulers and ruled, that the survival of the Fifth Republic may be brought into doubt in the next few years, ‘Europe’ or no ‘Europe’.”

– Excerpt from The Rotten Heart of Europe: Dirty War for Europe’s Money by Bernard Connolly

 

“How can you govern a country which has 246 varieties of cheese?” – Charles de Gaulle

 

In medieval France, there was a legislative and consultative institution, known as the Estates-General (French: États généraux), which gathered representatives from different classes of people across the land to advise on matters of national importance. When the representatives congregated in 1614 in Paris at the occasion of the uprising being organised by Louis II de Bourbon, the prince of Condé, they complained about corruption and high levels of taxation while still maintaining allegiance to the crown. The Estates-General did not reconvene again till 1789 when it was summoned by King Louis XVI. This time, however, the representatives did not merely complain but rather provoked the French Revolution.

Political change takes times. Yet Emmanuel Macron, in only 8 months since taking office and on the back of a large parliamentary majority, has been successful in effecting meaningful change in France. Most notable of all of Macron’s achievements to date is the signing of five decrees in September last year to reform France’s labour law. The implications of these decrees include:

  1. Streamlining social dialogue

When a company hires its fiftieth employee in France, it must comply with a long list of requirements, notably the nomination of workers’ representatives and the setting up of a works council and a health and safety committee. Under the reforms, the three employee representation bodies – the staff delegates (“délégués du personnel”), the Works Council (“Comité d’entreprise”) and the Health and Safety Committee (“CHSCT”) – will be merged into one single entity, called the Social and Economic Committee (“SEC”). Companies must set the SEC up by no later than 1st January, 2020.

The merger of the three bodies will reduce administrative costs and cut through significant amounts of red tape faced by large companies.

 

  1. Decentralisation of collective bargaining

Collective bargaining was generalised by law in France in 1950. This law established collective bargaining at the industry level as it was seen as the only way in which small companies could benefit from collective agreements. The introduction of the “Auroux laws” in 1982 imposed an added obligation on companies that have a trade union delegate amongst their staff – loosely companies with 50 or more employees – to negotiate pay and working hours annually – failure to do so could result in penalties.

Under Macron’s reforms, employers, in companies of less than 11 employees, will have the freedom to negotiate directly with their employees, on all topics open to collective bargaining, at company-level instead of industry-level. Agreement of terms between the employer and employees is subject to ratification by a majority of two-thirds of the employees. This new ratification method is also applicable to companies of 11 to 20 employees that do not have a trade union delegate.

The reforms also increase flexibility for businesses with 21 to 49 employees and no trade union delegate by allowing them to negotiate agreements with elected, but not unionised, employees.

Given that over 90 per cent of French companies have fewer than 50 employees and no trade union delegates, the decentralisation of collective bargaining is a major win for business. Companies are now less susceptible to being held hostage by powerful labour unions such as the General Confederation of Labour (CGT).

 

  1. Settlements for unfair dismissal

Firing employees in France has always been both challenging and costly. Up until the recent reforms, employees in France could obtain huge settlements for unfair dismissal and could make claims against their dismissal up to two years after the fact. Now, however, damages will fall within a set floor and ceiling and workers will now have twelve months to lodge their application with the tribunal for compensation for wrongful dismissal.

Damages for employees with two years of services are capped at three months’ salary with compensation increasing by a month’s salary for each year of additional service up to ten years. After ten years’ service, the annual increments are reduced to half a month’s salary. The maximum compensation is set at 20 months’ salary.

 

  1. Local not global profitability to assess case for lay off

In France, any plan to layoff multiple workers must be approved by a chamber of commerce. Judges have been known to block lay off plans or penalise companies by referencing the profitability of their global operations. This oddity, too, has been removed. Judges will now only be able to base their decisions on a lay off plan on the profitability of a company’s local operations. This is a major shift as global profitability has been the central issue over company shutdowns and restructurings in France over the years, most notably in ArcelorMittal’s attempt to lay off workers at Florange steelworks in 2013.

 

These labour reforms are certainly good for business. Administrative costs will be lower, transparency on potential damages arising from layoffs is higher, and multinationals will not be unduly penalised for the performance of their international operations. Employees, however, should also benefit. Companies will now be more willing to hire in good times as they know they will be able to shed staff, without onerous levels of red tape, in bad times. While wage gains will be limited as the combination of employers now having more flexibility in negotiating terms and the high unemployment levels in France give businesses a stronger hand, unemployment should decline.

France’s first budget under Macron, while not without its critics, is also another early success. The budget reduced the scope of the wealth tax to real estate assets and put in place a flat 30 per cent levy on capital gains, replacing the previous progressive tax on capital gains that went as high as 45 per cent. The corporate tax rate has been cut to 30 per cent starting 2018 and will be reduced to 28 per cent on 1 January 2020, 26.5 per cent on 1 January 2021 and 25 per cent on 1 January 2022. Until 1 January 2020, the corporate tax rate will remain 30 per cent.

The early reforms achieved by the Macron government should boost the domestic profitability of French companies over the coming 2 to 3 years; while at the same time strengthening the case for capital investment into France. Moreover, the reforms come at a time when Europe, collectively, is in a cyclical upturn. Thus enabling the French economy to both contribute to and benefit from this upturn.

Europe’s cyclical upturn is real and it is broad based. Industrial production, excluding construction, is picking up across the Eurozone.

Eurozone Industrial Production Ex-Construction YoYEurope Industrial ProductionSource: Bloomberg

If we look across some of the major European economies, the industrial production trends are similar.

Industrial Production Ex-Construction YoY for Major EU Economies Europe Industrial Production Major EconomiesSource: Bloomberg

Construction activity too is starting to pick up. Using the number of residential construction permits issued as a proxy; we can see that construction activity is witnessing a strong pick up in France and Spain.

OECD Construction Orders Permits – Residential Buildings IndicesConstruction Permits.pngSource: Bloomberg

Unemployment is declining as a result of the higher levels of economic activity.

Eurozone Unemployment Rate (%)Eurozone UnemploymentSource: Bloomberg

This is translating into improving consumer confidence.

European Commission Consumer Confidence IndicatorEC Consumer Confidence Source: Bloomberg

Business appetite for borrowing has also picked up with a strengthening economy.

European Central Bank Money Supply M2 YoYECB M2 YoYSource: European Central Bank

Given the still high levels of unemployment in the Eurozone and relatively frictionless labour mobility, nominal wage growth remains subdued and is likely to remain so until the labour market tightens significantly. And this, we think, will keep the ECB from tightening too quickly and instead allow monetary policy to remain accommodative for at least another 18 to 24 months, which should be supportive of profitability of Eurozone companies.

 

Investment Perspective

 

A strengthening Euro has thus far not derailed the recovery in the Eurozone. This is because the recovery is domestically driven and not by exports or as a consequence of an undervalued currency. The ECB’s accommodative policies have kept the cost of capital low, allowing companies to repair their balance sheets and increase profitability.

Comparing the price performance of the STOXX Europe Mid 200 Index – a representative index for mid-cap companies in Europe – to the trailing twelve months price-to-earnings ratio of the index, we find that over the last two years earnings growth, not multiple expansion, has driven the price performance of mid-cap European companies. In fact, the price-to-earnings ratio has contracted over the last two years by over 25 per cent while the index is up over 16 per cent.

STOXX Europe Mid 200 Price Index – Price vs. Price-to-Earnings RatioStoxx Europe Mid 200Source: Bloomberg

We prefer small- and mid-cap exposure in Europe over broad based equities exposure. We think a stronger Euro will be a headwind for many large-companies as most of them have a significant portion of their earnings coming from exports.

At a sector level in the mid-cap space, we like automobiles and components producers, consumer services companies, mid-sized Spanish banks, and insurance companies. Areas that we would avoid include food & beverage producers and distributors, media companies and mid-sized energy related plays.

* Note if you would like to discuss specific names please email us

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.