Beyond Bulls & Bears

A Slow Crawl for Spain, Europe

Patience is in short supply in the markets these days. At the risk of stating the obvious, the economic situation in Europe is fraught with uncertainty, which isn’t playing well with investors demanding to see clear solutions to the debt crisis there. Uwe Zoellner, Head of Pan-European Equity and Portfolio Manager for Franklin Equity Group based in Germany, has little patience for leaders who would rather stall than implement solutions, but also has a great deal of optimism that they ultimately will implement these solutions. And, he’s seeing signs of progress in Europe (of all places, Spain!) that others may be overlooking.

Uwe Zoellner

Zoellner’s key messages:

  • “I don’t think the U.S. needs another short-term aid to buy time, a ‘QE something.’ The U.S. needs a credible plan for deficit reduction.”
  • “From a valuation perspective, the Europe equity market, as reflected by the MSCI Europe Index, seems to be suggesting that we are experiencing the same type of structural stress we saw back in the 1970s, and that we are in for a long period of bad economic performance in Europe. Frankly, I don’t agree with that assessment.”
  • “I believe countries like Spain can regain their competitiveness, and we are already seeing a small improvement in terms of unit labor costs.”

Europe’s debt crisis is certainly souring investors’ appetite for risk, and Zoellner doesn’t blame them. While it doesn’t seem like growth is in the cards this year, at least for the southern periphery of Europe, he believes things will improve there in time, and the patient investor with the will to position himself for delayed gratification should be rewarded.

“It seems like many people were surprised to see a recession in the southern part of the eurozone this year, but really it’s almost inevitable with aggressive austerity. What can you expect when you cut back so much on government spending and make people nervous? To reduce a debt mountain, there is a price to pay.

Shorter term, yes, we are facing challenges. We can see it all over the world. It’s a vicious cycle. You have economic activity stalling, markets weakening, and politicians resisting until they are forced to take action of some type. Then markets stabilize, the impact wanes, and the cycle starts again. What will get us out? I look to the U.S., China and the eurozone. I am German, so I can’t get away from talking about deficit reduction. We can’t get away from it. I don’t think the U.S. needs another short-term aid to buy time, a ‘QE something.’ The U.S. needs a credible plan for deficit reduction. China needs to reinvent its growth model. I think China’s leaders have realized this, and are looking to boost domestic consumption and in different ways to stimulate the economy. I think we are seeing progress there.”

That leaves Europe. In the short term, Zoellner feels the banking sector is in need of stabilization, but the recent recapitalization of Spanish banks has represented important progress.

“I believe the ultimate solution for countries like Spain, Italy or Portugal is structural change but this will take time. Therefore, eurozone governments have to think about a way to keep countries afloat in coming years; financial markets are not ready right now to take a risk on the Southern periphery. So a kind of bridge financing is needed for the coming years. Different ways are possible; the European Central Bank (ECB) might play an active role and even the use of Eurobonds is possible in a limited way, for instance as a tool to finance a debt reduction fund.”

However, Zoellner rules out a full blown switch from national debt to Eurobonds as the way forward for public debt. Given pervasive market pessimism, it’s no surprise to him that overall, European stocks have moved to the bargain basement. However, as a long-term investor, he views the situation as one of opportunities, because he doesn’t believe the much-publicized extreme pessimism is warranted.

“Overall, European stocks, reflected by the MSCI Europe Index,  are looking cheap on a P/E (price-earnings) basis, and there certainly are reasons to be a bit cynical about earnings. It’s also true when looking at the price-to-book value ratio, which tends to be more stable over time. We see very depressed valuations, in some cases near where we were in the 1970s. From a valuation perspective, the market seems to be suggesting that we are experiencing the same type of structural stress we saw back in the 1970s, and that we are in for a long period of poor economic performance in Europe. Frankly, I don’t agree with that assessment. I see many individual companies with solid balance sheets and high levels of cash. There are some high net margins, and some companies have also seen some relief from recent drops in raw materials prices and benign labor costs.”

Source: MSCI. All MSCI data is provided “as is.” MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI. One cannot directly invest in an index. Past performance is not indicative of future results.

The price-to-earnings (P/E) ratio for an individual stock compares the stock price to the company’s earnings per share. (This figure is often calculated using trailing 12-month earnings, but some stock pickers use forecasted earnings.) The P/E indicates how much the market will pay for a company’s earnings. A high P/E usually indicates a strong belief in the company’s ability to increase those earnings. A low P/E indicates the market has less confidence that the company’s earnings will increase.  

Source: MSCI. All MSCI data is provided “as is.” MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI. One cannot directly invest in an index. Past performance is not indicative of future results.

For an individual company, the price-to-book (P/B) ratio is the current share price divided by a company’s book value (or net worth) per share. A P/B ratio lower than 1 indicates a company is trading below its book value per share (and, theoretically, below its liquidation value).

Spain: Slowly Seeing Progress

While the short term looks pretty bleak, Zoellner believes today’s bargain prices for select, quality European stocks can offer tremendous value for investors. To crystalize that value, he believes long-term structural changes are needed (in addition to short-term bridge financing) to make some of the struggling southern European countries more competitive again. Spain, in the throes of a banking crisis and facing double-digit unemployment, has felt the pain of that loss of competiveness.

“Clearly, Spain is in a difficult state, and high labor costs are a problem. There are many ways to reduce labor costs other than simply slashing nominal wages (as Ireland has done). For example, in 2004 Germany was in terrible shape, and underwent a decentralization of its labor markets. Negotiations took place at the company level, and many workers accepted a longer workweek for greater job security. The result was that wage costs overall in the country fell.  I believe countries like Spain can regain their competitiveness, and we are seeing a small improvement in terms of unit labor costs already.”

There is a mistaken view that Spain has virtually nothing to export; and therefore that labor cost improvement won’t matter much. Zoellner, however, has dug into the data, and has found that Spain has more to export than just tourists. Spain’s current account balance has also shown some promise. The current account is still in deficit, but the trade balance excluding energy is balanced now, which Zoellner said is a significant improvement over the past four years.

“Before the opening up of central Europe, the Iberian Peninsula was generally where the cheap labor was in the region, and production from other parts of Europe shifted there. Over time, Spain’s labor market got more expensive and production moved elsewhere, but Spain still has a significant industrial base, so an improvement in exports should be reflected in its economy. We are already seeing some signs of progress in terms of exports, and we might see a reallocation of manufacturing again from the northern European countries if there’s a competitive incentive again to go to Spain. Spain can also improve its plight by importing less, which helps aid domestic job growth.”

There is certainly no shortage of skeptics surrounding the eurozone’s survival, but Zoellner isn’t one of them. Zoellner reminds us again about Germany—the powerhouse of the Eurozone today—which less than a decade ago was called “the sick man of Europe.”

“People didn’t think the country could change—but it did. People kicked out their government after reforms were introduced and they protested in the streets. This kind of reform is never popular. But It happened anyway and that is what we see in Southern Europe today.. Patience is just out of favor.”

Beyond Bulls & Bears is curious: What do you think? Can Europe recover? Please let us know in the comments.

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