Europe Reworked

The impact of political change

MICHAEL BROWNE, PORTFOLIO MANAGER, EUROPEAN LONG/SHORT, MARTIN CURRIE INVESTMENT MANAGEMENT

Politics will undoubtedly remain one of the key macro themes for Europe over the next 12 months. A packed list of elections, rising anti-establishment sentiment and the re-emergence of Greek debt will all play a crucial role in determining the future direction of the European Union (EU). In this article I assess the opportunities for investors as Europe’s political landscape is redrawn.

TAKING EUROPE’S TEMPERATURE
Germany: Europe’s strongest economy, but Merkel faces challenges

It is impossible to discuss Europe without first looking at Germany. There is a clear gap in economic terms between the country and its counterparts, yet there is surely a limit to how long the miracle of success can continue. Germany is the world’s third largest exporter with a trade surplus of 189 billion euros1. Given the importance of foreign trade, the country is very much in the firing line from overseas factors, particularly from China and the US (its two largest export destinations outside the EU). Slowing Chinese growth, coupled with a potential adverse economic reaction to the US presidential election, could mean a risk of slippage in foreign orders. With this in mind, federal elections in the second half of next year could have a profound effect on the country’s economy. Angela Merkel (who would be looking for her fourth term as chancellor) and her Christian Democratic Union (CDU) party are in a far from comfortable position. Staunchly anti-immigration Alternative für Deutschland (AfD) has made gains at Merkel’s expense (as her response to the European refugee crisis comes under scrutiny) and looks certain to enter the Bundestag for the first time. However, sharp growth in support for the left since the 2013 election, alongside the CDU’s slump, is likely to leave the door open to more influence for centre-left parties. This implies more support for introducing green taxes, charges on financial transactions and higher corporation tax – all of which would not be favoured by financial markets.

Italy: Grillo’s rise brings greater EU scrutiny
Italian growth has been weak, with its banks, in particular, threatening Europe’s overall financial situation. This has left authorities searching for a solution to the banks’ ever-increasing nonperforming loans and attempting to shore up the overall solvency of the system. This December’s constitutional referendum will therefore be as much a reflection on Italian dissatisfaction with the economy, as it will be about its nominal purpose – curtailing the powers of the senate. Prime Minister Matteo Renzi may resign if he loses, which would spark a snap election. However, whether or not an election is held next year, the momentum behind Eurosceptic Beppe Grillo’s Five Star Movement means the wider debate over whether the country should leave the euro, or even the EU, is not too far away. The key issue though for the country’s economic and political stability remains not at the ballot box, but in finding an effective solution to prop up the ailing banking system.

France: a return for the centre right, but Le Pen waiting in the wings
France’s weak economy puts it in a similar bracket to Italy (although without perhaps the same potential to blow up). It seems certain that current president, socialist François Hollande, will not make May’s second-round run-off for the Presidency. Instead, it will be a contest between a centre-right candidate (possibly former prime minister Alain Juppé, or ex-president Nicolas Sarkozy) and far-right Front National leader Marine Le Pen, who is anti-establishment and anti-EU. Polling would suggest the most likely outcome would be a right-of-centre, moderate French government with mild reforming characteristics, which would be viewed by the market as ‘business as usual’. However, unlike 2002 (the last time Front National reached the second round) when Jacques Chirac defeated Le Pen’s father by a landslide, the election is expected to be close. For France, a country which considers itself at the heart of the European project, a Le Pen win (unlikely, but not impossible) would be a major shock for markets.

Netherlands: Freedom Party on the rise, but is it enough?
Geert Wilders’ PVV (Freedom Party) is one of the most prominent anti-establishment parties in Europe. Firmly Eurosceptic and advocating an EU exit for the Netherlands, it has seen a huge rise in popularity since it was formed around a decade ago. However, Wilders’ poll ratings have slipped since the beginning of this year and next May’s Dutch election result is too close to call. It is likely that, following the vote, there will be a prolonged period before the makeup of the next coalition government is agreed on. The end result could still be a relatively pro-EU administration, the Netherlands being one of the states which has backed Germany over issues such as bank bailouts.

Spain: no government and in cruise control
In terms of political volatility, Spain should be at the top of the pile. Two elections have failed to produce a government, and a third is due at the end of this year. However, far from collapsing due to the lack of government, the country is doing perfectly well despite the deadlock. The situation would be made more difficult if important decisions were called for, but GDP numbers boosted by tourists avoiding France and Turkey, has made this outcome less likely. Within Spain, there is a very obvious pro-EU majority and support for the left-wing party Podemos (which has been more critical of the EU) would appear to be waning.

UK: Brexit vote puts matters on pause
Although the UK’s vote for Brexit started the ball rolling, setting the stage for anti-establishment parties across the continent, the UK is not really an issue for the rest of Europe in 2017. There is no formula in place for the country to secede membership, and discussions over the exit deal between the UK government and EU leaders will not start in earnest until this crowded period of elections is over. Even then, once article 50 (the formal notification of leaving the EU) is enacted, the process will take another two years to complete. The markets, meanwhile, appear to have accepted Brexit, even if they are not clear yet on exactly what it means.

Greece: the debt crisis revisited
The resolution to Greece’s sovereign debt crisis in 2015 – a bailout deal agreed following protracted negotiations with the ‘Troika’ of the European Commission, European Central Bank (ECB) and International Monetary Fund (IMF) – was always going to be a temporary one. The situation has not improved and 2017 could be the year the banks finally run out of road. Greece’s economy is now bypassing these banks entirely. Importantly, none of the deposits are coming back, giving them no chance of growth. While Prime Minister Alexis Tsipras successfully led a referendum in 2015, rejecting the Troika’s bailout terms, he is losing popularity and there is very little that can be done politically to rescue the situation. A new government might break the logjam, but elections are not due until 2019. With the UK already leaving the EU, Greece being forced out of the euro fundamentally changes the landscape, raising the risk premium for Europe.

Portugal: ‘Greece mark two’
Unlike its Spanish neighbours, Portugal is on much shakier ground. On the political front, after an inconclusive general election last year, a leftist alliance secured power against a backdrop of strong anti-EU feeling in the country. Unlike Greece, Portugal was able to leave the bailout programme in 2014, after meeting ECB and IMF targets. However, the failed sale of Novo Banco reflects poorly on the overall health of the banking industry, while the country still has a high debt-to-GDP ratio, and (as seems likely in Greece) could be forced out of the euro. While there are signs the bond markets are beginning to price this in, this has yet to be reflected in equity markets.

Galvanised by change
In an increasingly fractured political environment, consensus may appear hard to come by. However, the potential for change may in actual fact provoke harmonisation. The backdrop of continued low growth and political separatism could be the catalyst for individual governments taking action to stimulate their respective economies, which could shift the region’s overall direction. We believe administrations are now more likely to use fiscal measures, particularly considering the ECB’s loose monetary policy appears to have run its course.

To be effective, the emphasis for government spending will need to be on ‘shovel-ready’ projects which will have an immediate impact (not taking decades to come to fruition like a high-speed rail link). From an investment point of view, it is from this area that we would expect to see the most interesting prospects for long-term growth stocks.

There is already evidence of projects with a high cost of capital, such as housebuilding or infrastructure, becoming more popular in the low interest-rate environment. Companies in materials and industrials sectors would benefit if governments look to increase direct spending. This would include businesses such as Irish firm CRH, which manufacturers and supplies materials and products for buildings, roads and infrastructure. The company has already reported a good first half of the year with a 35% increase in sales, and says there has been a ‘modest impact’ from early stage economic recovery in Europe. Meanwhile, although UK housebuilders have seen their fortunes dip following Brexit, there are positive signs for those companies with pan-Europe real estate exposure. Residential property prices have risen across much of Europe, with notably strong markets in Germany and Ireland.

Protecting the downside
Of course, the likelihood of increased fiscal stimulus still very much depends on the makeup of the political map at the end of 2017. Fiscal and tax reform isn’t going to happen under the current French administration, but might carry more weight under a more centre-right leaning government. Likewise, under a more left-leaning Germany, attempts to implement these kinds of reforms might go backwards.

Should the risk parameters rise, for example from another Greek collapse, or a far-right government in France, then it is important for an investment strategy to be able to take a flexible and pragmatic approach. In these circumstances, a long/short approach is invaluable. While some of these growth themes require a longer time horizon to play out, in the shorter term, the possibility to short companies failing to adapt to the current economic environment allows us to manage volatility and protect the downside.

Reflecting this, the current scenario of low-growth offers a number of short-side opportunities, with banks the obvious starting point. We have seen falling margins driven by interest rates and institutions which are very slow in the process of cutting costs out of their businesses. Airlines too are suffering, due to overcapacity and falling demand, together with the impact of oil hedging and an inability to pass costs onto consumers until next year. But, irrespective of the short-term political upheavals happening in the next 12 months, what shouldn’t be forgotten is the inherent quality of many European companies. The fact remains that Europe is home to many world-class businesses. These are leaders in their sectors, deriving their revenues from international as well as domestic sources, with a solid foundation for long-term growth.

Footnote

1.Source: Federal Statistical Office of Germany, Federal Ministry for Economic Affairs and Energy