Low labour cost eastern European countries could hold one of the keys to Europe's economical future, as well as opening up new consumer markets
Europe was something of a favoured market with investors in the latter half of the 1990s, offering some stellar returns and some punchy growth funds.
Since the crash it has fallen from grace, with investors either switching to fixed interest or keeping their money closer to home, often in UK equities. But there is plenty happening on the Continent from the expansion of the EU eastwards to the ongoing effects of a single currency and interest rate policy.
The latest Conjecture debate looked at just such issues, with an expert panel from Merrill Lynch, Henderson and DWS Investments.
Are European stock markets cheap on a global basis?
Paras Anand (PA): You could argue Europe's cheap relative to the US, although more expensive relative to Asia if you looking at things like price/earnings (P/E) or price-to-book. But it is easy to explain the cheapness of European markets if you look at some of the structural barriers to economic growth: high unemployment, inefficient government and labour market structures and an expensive currency.
Hu Aarts (HA): European equities are trading on 14 times earnings and a price-to-book of around 1.8 times, compared with 18 times earnings and 2.2 price to book for the US. This is partly because of the structure of the index, some 27% of the pan-European index is banks and banks on average have lower P/E and price-to-book multiples.
John Botham (JB): European markets are probably close to the cheapest that they have been for the last 30 years.
So where are the earnings going to come from in Europe over the next few years?
HA: Earnings, long term, for Europe grow more or less in line with the US. The return on that equity on the internal assets in Europe is still 2%-3% lower than in the US. This explains the lower valuation, but there is still healthy earnings growth and sustainable margins over the next two years.
JB: Returns on equity are lower in Europe as companies generally are less aggressive with their balance sheets than is often the case in the US, and also because corporate tax rates are, in many cases, higher in Europe. But we will see European firms using their balance sheets more efficiently, either via paying back excess capital through higher dividends or share buy backs.
At the margin, we are seeing evidence that may be as a result of the threat from Eastern Europe. Some countries are lowering their corporate tax rates, in particular Austria and I believe recently Greece announced some proposals to lower their tax rates.
PA: I am probably more measured in my enthusiasm about the prospect for earnings growth going forward. Much of the earnings growth that we have seen over the past couple of years has been driven by cost-cutting and balance sheet de-leveraging. But going forward I think it is more difficult to see, for example, consumers supporting the economy as they have done over the past couple of years and, similarly, it does not seem from my meetings with companies that we are about to see a big upswing in corporate Capex.
What do you think about EU moves to improve corporate governance in the aftermath of Parmalat?
JB: Levels of corporate governance vary enormously throughout Europe. There are certain markets where events or activities are permitted that would not be tolerated in other markets. I applaud the efforts of the EU to try and unify and raise standards. A lot of the issues in Europe relate to the fact there is a much higher percentage of companies which retain significant family ownership.
HA: Corporate governance varies by company and it is up to the portfolio managers to take a view on a case-by-case basis. During the bull market, everything was moving up and seemed fine and people did not care so much about the accounts. Now there is much more debate about this.
PA: Bear markets bring home a lot of reality to firms and you have seen that it has changed, not only in terms of corporate governance and disclosure. I think it has given Europe a push in the right direction.
How much further is the dollar going to fall and what will that do to Europe's competitiveness?
PA: I do not know where the dollar will go in an environment of lower growth, but the one thing that is in favour for a lot of European firms is there is still a lot of change that can take place within corporate Europe itself.
JB: In the long run, the dollar should fall. As to the impact that would have on Europe, I think we should look at the recent experience with the dollar devaluing from 83¢ to the euro to about 123¢ to the euro. A lot of the observers have been positively surprised as to how well the European companies have coped with that.
What has been the effect of the single currency and interest rate policy?
PA: It has created some disparity between the underlying economic performances of different countries in the region. Arguably, it has been restrictive for some of the core countries but accommodating for some of the peripheral countries. However, one real positive about the single interest rate policy that often gets overlooked is that it was absolutely fundamental to have that in order to create a credible currency.
HA: We have seen some countries such as Ireland and Spain doing well and others like Germany and the Netherlands not performing so well from a GDP point of view. That is something we have seen in the US as well. Although we have one economy, one currency and one interest rate scenario you still have various states performing differently due to the local production. One state is more service-oriented and another state is more capital intensive, therefore you will have different unemployment rates in different states. Going forward in Europe you will continue to see the difference.
Could you focus in a little more specifically on Germany? It is such a big part of the European economy.
HA: It is not good for the German economy but increasingly other companies in Europe have been less dependent on Germany over the past few years, especially with Asian growth taking off. It would be beneficial for Germany to be more flexible on the labour front and be more flexible perhaps on pensions and tax rates too. It will then take another three to four years for Germany to perform as well as France.
JB: This one-size-fits-all has meant Germany has suffered with a higher interest rate and a stronger currency than it would have had otherwise. Nevertheless, it seems Germany is finally beginning to take the first tentative steps in beginning to deal with some of its more structural issues.
Is there any evidence of industries moving from one part of Europe to another on the back of the single currency?
HA: We have seen little of that, but we have seen a shift into eastern Europe due to cheaper labour, cheaper land, the high education standards and the worker motivation is as good as in the West.
JB: Despite a single market and a single currency there remains a great deal of nationalistic tendency within Europe. For example, the Bank of Italy is continuing to block any foreign takeovers of Italian banks. Until some of those issues are resolved and there is a greater degree of harmonisation in taxation, I think it will be difficult to ever call Europe a true single market.
How important is domestic demand and are there tangible signs of recovery? If so, shouldn't small and mid caps with a domestic bias be favoured?
HA: The answer is yes. For evidence of the domestic recovery look at Spain, Ireland and even the UK. The domestic stocks like the housebuilders, the mortgage lenders have done very well.
PA: I'm a big flag-waver for small and mid caps as I think that is the level you can find global leaders in fast-growing market niches and you can get a clearer grasp of the factors that are affecting those companies directly. We have always had Asia as being this place where people can access cheaper labour, but now it is on our doorstep. There was a very interesting case with Siemens where it was negotiating to move plant to Hungary and in the end, the union accepted the longer working week for the same pay, so it has proved very effective in terms of that threat. I think also it does open up new consumer markets.
JB: The Eastern European countries have been on the process toward convergence for the past 15 or 16 years.
HA: The only benefit is the opening of a consumer market where you get probably an increase in GDP. Western companies could also shift production to lower labour cost countries. But if all the companies are going to do that I think it will take three or four years and the competitive advantage will compete away.
How is the advent of the 10 countries affecting portfolio construction and what sort of corporate governance standards are there in these markets?
JB: There is a big difference still between some of the countries such as the Czech Republic, Hungary and Slovakia and the like, and shall we say the wilder east as in Russian or the Ukraine.
Pre-Euro and pre-market crash, everybody was big on sector investing. Is that still the best way to make money in Europe?
JB: I think most of us have always, even going back 10 or 15 years, had a strong sector influence in the way we have invested.
The advent of the single currency, unification of risk premiums around Europe and some convergence, in terms of accounting standards and reporting standards have made it easier to analyse stocks and sectors on a cross border basis.
Nevertheless, Europe is not, and perhaps will never be, a single unified economy, therefore at the margin there will always be individual country influences.
HA: I think it is dependent on the sector. With global sectors such as oil, you really have to look at the valuation of stock, so BP versus Shell, for instance. If we go to the retail sector its very much a domestic call.