Carmignac’s Didier Saint-Georges sees an unhappy Europe
The results of the latest European elections send a clear message of un-happiness, suggests Didier Saint-Georges, member of the Investment Committee at Carmignac Gestion.
Without getting into deep political analysis, it is fair to say that any European investor contemplating the European equity markets’ rally of more than 50% over the last two years must consider the economic significance of the election results on 25 May. By sending around 140 MEPs (a quarter of the chamber) opposed to the European project to the European Parliament, the public has registered a level of protest not seen since the creation of the Union 22 years ago.
Indeed, after five years of crisis, the real economy would appear to be performing disastrously: average growth of less than 1% and unemployment of nearly 12%, i.e. 26 million citizens. Naturally, this situation is reflected in the success of populist rhetoric and its barrage of haphazard accusations regarding the market, Brussels, Frankfurt, banks, the wealthy and immigrants, etc.
Failing governments cannot ignore this warning shot. And investors need to integrate in their thinking the lack of European growth. Clearly, the United States’ response to the crisis was much quicker than Europe’s.
The lessons from Sweden and Japan’s experiences in the 1990s were there for all to learn but evidently they were much better noted in the United States (especially the need to get banks back on their feet quickly to facilitate the transmission of an extremely accommodative monetary policy). However belatedly, Europe should close this gap soon by completing the increase in banks’ capital adequacy ratios following the Asset Quality Review, and by the ECB adopting a radically unorthodox monetary policy.
The central bank’s stronger role is essential and a prerequisite to any recovery, but it will take more than that to kick-start real economic growth.
One basic observation captures the lag accumulated by the European economy in a nutshell: in 2013, European corporate earnings stood at just 55% of their 2007 levels (EPS for Eurostoxx 600 companies).
By the same year, US corporate earnings (S&P 500 companies) were already more than 30% above their pre-crisis levels. This is therefore not surprising that investment, consumer spending and therefore employment would be struggling in Europe. Financed through public spending cuts, a reduction in the charges weighing on companies is therefore essential to drive an improvement in net margins (at their lowest level since 2002, whereas they are now at a high in the United States). Such efforts are well underway (even in France it would seem!) but will inevitably be very gradual. And as for business volumes, what can we expect for European companies?
A slight recovery in domestic demand has been seen since the spring in the eurozone, helped by a stabilisation of fiscal pressure. However, the extent of this improvement will remain limited by a weak labour market and governments’ minimal budgetary leeway. The sluggishness of domestic demand is therefore making external trade the main source of recovery.
The spectacular turnaround in the eurozone current account balance since mid-2012, with a historic surplus seen in recent months, is the main indicator of this trend. To some extent, this progress also explains the resilience of the euro over the period, which only some countries have managed to offset with massive gains in competitiveness.
Along with Spain, Portugal is a good example of restoring external competitiveness through economic devaluation (lower wages, job losses).
The real exchange rate of the euro (measured in labour cost) for Portugal has returned to its 1999 levels, fuelling a sharp increase in exports, which are now 15% above their 2007 levels. This progress has breathed life into investment and, like Spain, the country has now emerged from recession. Added to structural reform of employment law and corporation tax, this progress last month allowed Portugal, following on from Ireland, to be released from the supervision of the international support plan introduced in May 2011.
However, let’s be lucid about the impact of this success. First of all, the huge social cost of this economic devaluation, which has also happened in Spain, is no longer an acceptable political prospect for other eurozone countries. A more competitive euro has therefore become essential.
Also, release from the international support plan does not end the need for fiscal austerity (even if the Socialist Party, which won the European elections in Portugal, returns to power at the October 2015 elections, controlling public debt equal to 130% of GDP will maintain the fiscal constraints). So even countries that have now become virtuous can offer only a very slow improvement in economic growth, especially as the global economy is not accelerating. As we predicted in our April newsletter (“On a clear day, you can see the US locomotive”), the United States is emerging – however slowly – from its soft spot in the first quarter and will probably register growth of around 2.5% in 2014, well above the rate seen in Europe. However, combined with the emerging market slowdown, this rate will not be enough for foreign trade to offset the weakness of domestic demand throughout the eurozone.
“The supreme quality for leadership is unquestionably integrity. Without it, no real success is possible” Dwight D. Eisenhower
European leaders therefore have no choice but to correct past management errors by boldly continuing (or starting) essential structural reforms. So economic growth will, at best, remain hindered by the need to cut debt. However, household confidence can still be regained if leaders show a clear vision and act accordingly.
Matteo Renzi’s success in the European elections shows that this proposal is a credible alternative to electioneering. As regards the European project, there is no doubt that an improvement in governance is essential if it is to no longer be suffered by governments but rather seen as an advantage. As Michel Barnier rightly put it, without belonging to a strong Europe, no single European country will be in the G8 by 2050.
Investors can feel confident as long as they keep their eyes wide open. For our part, we remain confident that the European economy is gradually improving, reflected in our positions in Italian, Spanish and Portuguese sovereign debt and financial corporate bonds. However, clear-minded about the outlook for growth, which is much poorer than elsewhere, we are mainly positioned in shares of global leaders able to withstand deflationary pressures. Our enthusiasm is mainly directed towards certain interdisciplinary themes (especially energy, technology and healthcare), and very strong local trends such as in India, where we think Narandra Modi’s election victory heralds real change. Finally, we remain vigilant, as the slowness of the recovery leaves Europe particularly vulnerable to external shocks.