Europe at a CrossroadsThe Outlook and Opportunities iShares Market Perspectives | November 2012
iSHARES MARKET PERSPECTIVES  Recent actions by the European Central Bank (ECB),Executive Summary coupled with positive news out of Germany and the Netherlands, suggest that Europe may have turned the corner. Investors have turned more bullish on Europe, and in recent weeks we’ve witnessed significant inflows into European equities. However, while we believe that the ECB has significantly mitigated the tail risks, there is still much work to be done to address Europe’s structural imbalances. The good news is that, in the aggregate, Europe is solvent. In addition, by lowering bond yields the ECB has bought politicians time. They must now use this respite to address the structural flaws that hamper growth and leave the banking system at risk. While Europe’s politicians have shown some resolve in addressing these issues, they will need to act with a greater degree of urgency. We still believe the odds favor further integration. The question is, can Europe’s political class move fast enough to satisfy financial markets and address economic realities? In assessing the outlook for Europe, we see three main areas requiring further reform. First, Europe needs to move closer to some form of fiscal union to match the existing Russ Koesterich, monetary union. Second, banks need to be recapitalized and regulation synchronized. Managing Director, Finally, the southern part of the continent needs to address structural rigidities in the iShares Chief Investment Strategist labor markets, which have hampered growth for more than a decade. While all of these reforms are economically viable, and should ultimately improve Europe’s long-term growth potential, they will be politically difficult. Politicians face entrenched interests that will seek to slow or block reform. We would further expect some reluctance on the part of politicians themselves. In one form or another, fiscal union will entail some loss of sovereignty for all of the nations in the European Union (EU). While the political desire for a more integrated Europe may be sufficient to overcome the inertia, it will still take several more years to address all the outstanding issues. Given this dynamic, we would remain generally underweight European stocks, but would be buyers of northern European equities. In particular, we like German, Dutch, and Norwegian stocks, all of which appear undervalued relative to the fundamentals. Should we see further evidence of structural reforms, cheap valuations would suggest a more aggressive stance in Italy and Spain as well.
iSHARES MARKET PERSPECTIVES Solvent But Structurally Flawed ratio of roughly 85% (see Figure 1). While this is up significantlyOh, London is a man’s town, there’s power in the air; from the 2008 trough of 60%, it compares favorably with theAnd Paris is a woman’s town, with flowers in her hair; United States, where gross debt-to-GDP is nearly 100%, andAnd it’s sweet to dream in Venice, and it’s great to study Rome; Japan. For investors who want to fixate on countries withBut when it comes to living, there is no place like home.” unsustainable debt burdens, Japan is in a class by itself: the—Henry van Dyke country’s debt-to-GDP ratio is more than 225%.Over the past several years, any investor outside of Europe has That said, although overall European debt levels look manageable,done well to stay closer to home. Since January 2010, European the euro-wide statistics mask significant differences by country.equities have fallen by roughly 16%, while global equities have Not surprisingly, Greece is in the worst position. Despite severaladvanced 10% and stocks in the United States have gained more rescue packages and write-downs, Greek debt-to-GDP still standsthan 25%. at more than 150% (see Figure 2), a level that most economists would argue is unsustainable, even for a normal economy. ForHowever, with the European Central Bank’s recent announce- Greece, which has been contracting by 5% to 7% a year since thement of more aggressive monetary policy, and a positive ruling start of the crisis, it is difficult to envision a scenario under whichregarding the European Stability Mechanism (ESM) from theGerman Constitutional Court, investors are getting moresanguine regarding Europe. In the third quarter through late Figure 1: European Debt-to-GDP RatioSeptember, $5.9 billion flowed into European developed market (1996 to Present)equity exchange traded products (ETPs). By comparison, thesecond quarter witnessed a $0.3 billion outflow. Year-to-date, $5 85%billion has flowed into European ETPs, of which September 80%accounted for more than $3 billion of those flows. 75% Debt-to-GDP 70%For investors who believe that Europe has avoided a crisis, the 65%attraction of European equities is not hard to understand: theyare trading at a big discount, both to their history and to other 60%countries. After underperforming global equity markets for the 55%past several years, European equities are particularly cheap 50%compared to the rest of the world. Stocks in the United States 1/96 1/98 1/00 1/02 1/04 1/06 1/08 1/10trade at approximately 2x book value. By comparison, Europeanequities are currently trading at a bit more than 1x book value. Source: Bloomberg as of 8/31/12.In addition, actions by the ECB have removed some of thenear-term tail risk associated with European equities, while therisks associated with the United States, in the form of the fiscal Figure 2: Debt to GDP Ratioscliff, have risen. Many investors who have been underweightEurope for several years are asking if this is the time to move Greece 160.6 Italy 123.5back into European markets. This leaves the question, what does Ireland 116.1Europe need to do to address its remaining problems, and how Portugal 113.9should investors position themselves in the interim? Belgium 100.5 Euro area 91.8 France 90.5In examining the long-term case for Europe, it is worth starting UK 91.2with the issue that has been plaguing Europe since early Germany 82.2 Austria 74.22010—European sovereign debt. Much of the debate surround- Spain 80.9ing the longevity of the euro has centered on the European debt Netherlands 70.1burden and its sustainability. Finland 50.5 Denmark 40.9 Sweden 35.6On this topic, investors can take some relief. European sovereign 0 25 50 75 100 125 150 175debt has risen dramatically in recent years—along with much of Government Gross Debt as a Percentage of GDPthe developed world—but the aggregate burden appears 2012 Forecast 10 Year Averagemanageable. Currently, the eurozone has an overall debt-to-GDP Source: http://graphics.thomsonreuters.com/F/09/EUROZONE_REPORT2.html (accessed August 31, 2012)
iSHARES MARKET PERSPECTIVES this debt will be paid in full. This suggests that ultimately Greece seems, as the country is running a primary surplus and, likewill need an additional write-down or will have to at least partially Japan, tends to fund most of its deficit domestically).default. But whether or not a Greek default, coupled with an exitfrom the euro, represents an existential threat to the euro largely Outside of Ireland and southern Europe, debt levels appear moredepends on the state of the European banking system at that time reasonable. For most of northern Europe, debt levels are at or(which we’ll cover in the next section). below 80% of GDP. While it is true that even in northern Europe debt levels are above their 10-year average, this is equally trueBeyond Greece, other parts of the periphery also look vulnerable, for countries outside of Europe.albeit to a lesser extent. Thanks to the bailout of its bankingsystem, Irish debt stands at 116% of GDP. In southern Europe, Looking beyond sovereign debt, the picture changes somewhat,both Italy and Portugal have debt burdens in excess of 100% of but not the overall impression. Europe in the aggregate stillGDP (in the case of Italy, this may not be quite as dangerous as it appears quite solvent. The accompanying table (Figure 3) chartsFigure 3: Indebtness and Leverage in Selected Advanced Economies United United Euro Japan Canada Belgium France Germany Greece Ireland Italy Portugal Spain States Kingdom Area General government debt 1 Gross 107 238 88 85 90 99 89 79 153 113 123 112 79 Net 84 135 84 35 70 84 83 54 n.a. 103 102 111 67 Primary balance -6.1 -8.9 -5.3 -3.1 -0.5 0.5 -2.2 1 -1 -4.4 3 0.1 -3.6 Household debt 2 Gross 88 74 99 89 70 53 63 59 70 120 51 105 89 Net 4 -226 -236 -178 -151 -123 -191 -127 -118 -48 -68 -171 -124 -72 Nonfinancial corporate debt Gross 3,5 87 143 118 53 138 178 152 63 75 244 112 154 196 Debt divided by equity (%) 82 184 86 45 106 53 85 107 264 84 139 144 149 Financial institutions Gross debt 87 177 742 60 142 124 169 97 33 691 97 63 109 Leverage of domestic banks 6 11 23 22 18 23 27 24 28 15 24 19 16 20 Bank claims on public sector 3 7 79 8 18 n.a. 23 17 21 29 27 32 19 26 External liabilities Gross 3,7 146 66 717 93 191 403 255 219 207 1717 142 286 221 Net 3,7 16 -52 11 11 14 -64 9 -33 97 93 23 107 93 Government debt held abroad 8 30 19 25 17 25 57 56 48 87 66 49 62 28Source: Global Financial Stability Report, “The Quest for Lasting Stability,” IMF, April 2012.1 WEO debt projections 20122 Gross debt minus financial assets that are debt instruments3 Most recent data divided by WEO projection for 2012 GDP4 Calculated with flow of funds data on financial assets and liabilities5 Includes intercompany loans and trade credit, which can differ significantly across countries6 Ratio of tangible assets to tangible common equity7 Calculated from assets and liabilities reported in each country’s international investment position; includes data on International Financial Services Centers8 Most recent data from JEDH divided by WEO projection for 2012 GDP: JEDH and WEO debt data are incompatible when one set is at market value and the other is nominal.
iSHARES MARKET PERSPECTIVES sovereign debt, but also household debt, corporate debt, debt in 2013—this will alleviate some of the pressure on Spanishof financial institutions, and external debt (the portion held by bonds. But for now, the jury is still out on whether Spain caninternational creditors). A cursory examination suggests that deliver on this target given continuing economic deteriorationseveral of the southern European countries do indeed have an and growing popular resistance to further austerity.overstretched consumer, as does the United States. However, onthe whole euro-area countries have gross consumer debt that Outside of Greece and Spain, most European countries, havingcompares favorably with other developed countries. Gross already undergone significant fiscal contractions, have broughthousehold debt in the euro area is 70%, compared to 88% in their deficits to below 6% of GDP. While Europe is still in thethe United States and nearly 100% in the United Kingdom. midst of a recession, further short-term improvements may be difficult to come by and arguably counterproductive. But fromWhere Europe does appear vulnerable is its banking system. a structural standpoint, most of Europe has made significantIreland was a cautionary tale of what happens when a country’s progress in starting to address their fiscal problems.banks grow too large compared to the overall economy. Irelandwas a particularly acute case, but the problem is endemic Closer Union Requires Less Sovereigntythroughout much of Europe. Overall European financial debt is While Europe is slowly climbing back toward a more sustainable142% of GDP, double the level of Canada or the United States. fiscal path, bond investors are not known for their patience—USThis highlights that a critical area for near-term reform is the Treasury investors aside. The continuing challenges facing Spainbanking sector. In particular, Europe will need to both recapital- and Portugal suggest that unless the ECB is willing to fund theseize and better regulate its banks. countries indefinitely, bond yields may start to rise again. In order to avoid this scenario, and sever the dependence on monetaryMoving from debt to deficits, the picture looks similar. Europe’s policy, Europe needs to move toward a tighter fiscal union, ideallyfiscal position deteriorated sharply in the aftermath of the one that involves some form of pooling of sovereign obligations.financial crisis, but Europe’s aggregate deficit is improving and is There are many versions this arrangement can take, but all needalso considerably lower than in the United States (see Figure 4). to fulfill two conditions: a mechanism to ensure balanced budgets over an economic cycle and some arrangement for theAgain, the euro-wide numbers mask significant differences. Not pooling of at least a portion of European sovereign liabilities.surprisingly, Greece is still the problem child of Europe. AlthoughIreland’s recent deficit was nominally higher, this is a function ofits banking commitment rather than a structural problem, as isthe case in Greece. Following Ireland and Greece, Spain is the Figure 5: Eurozone Country Surplus/Deficitbiggest risk. Not only is its deficit large, at roughly 8% of GDP, butas most investors are aware, the country’s size makes a full- Spain Sloveniascale bailout much more expensive and daunting than for the Slovakiaother peripheral countries. The hope is that if Spain can deliver Portugal Netherlandson its commitment—which would entail a fiscal deficit of 4.5% Luxembourg Italy Ireland Greece GermanyFigure 4: EU-27 Deficit-to-GDP France Finland(1997 to Present) Eurozone 1% Estonia Cyprus 0% Belgium -1% AustriaDeﬁcit-to-GDP -2% -14% -12% -10% -8% -6% -4% -2% 0% 2% -3% Fiscal Deﬁcit as a Percentage of GDP -4% -5% Source: Bloomberg, as of 8/31/12. -6% -7% -8% ‘97 ‘99 ‘01 ‘03 ‘05 ‘07 ‘09 ‘11 Source: Bloomberg, as of 8/31/12.
iSHARES MARKET PERSPECTIVES Ultimately, for an effective monetary union, fiscal arrangements granting joint guarantees for debt above 60% of GDP. Thewill need to be designed to share fiscal risk before a crisis erupts, approach would have certain similarities to bonds issued by thenot after. Without some form of risk sharing, countries will European Financial Stability Facility (EFSF), but financing wouldcontinue to face very different financing conditions and remain be an instrument available to all countries outside any crisisprone to having liquidity crises turn into solvency concerns.1 context. To ensure sufficient creditworthiness, some additional collateral would be provided by issuing countries.There are various ways to accomplish these two goals. Mecha-nisms to share risk vary from access to common bond issuance The path toward closer fiscal integration needs to be based on anto a full-fledged fiscal union with a large federal budget, but they explicit bargain: northerners agree to some form of joint liabilitiesall have one thing in common: the surrender of a considerable in return for credible guard rails on spending and budgets of alldegree of national fiscal autonomy. In order to facilitate this type eurozone members. Given the implied loss of sovereignty it willof change, a further strengthening of the role of the euro-area likely be a slow, tortuous path getting there. In addition to all of theinstitutions will be essential. The most direct mechanism for challenges inherent in this effort, we are beginning to see separat-pooling liabilities would be the issuance of euro-wide bonds. Euro ist movements and tensions in countries such as Spain, which willbonds would provide the following benefits: risk sharing, greater only exacerbate the difficulties. However, we believe that most ofresilience to external shocks, breaking the so-called “banking- the governments will ultimately acquiesce to this deal.sovereign feedback loop” (in which a nation borrows to recapital-ize its banks, pushing up yields and making it more difficult to One Currency, Multiple Regulatorsfund the banks) and providing a liquidity premium (by trading in a Moving toward a fiscal union is a necessary condition for the euro’sunified sovereign bond market, euro bonds would deliver a long-term survival, but it is not the most pressing problem. Thankssubstantial liquidity gain, theoretically lowering borrowing costs).2 to the ECB’s Outright Monetary Transaction (OMT) operation—under which the ECB agrees to buy unlimited short-term sovereign debt inWhile the term euro bonds has gained in popularity, there are return for a formal request for aid and conditionality—Europeanvarious forms this solution can take. At its most complete, full politicians can proceed at a more measured pace on fiscal union.euro bonds would entail that all euro-area sovereign financing be Although the market’s patience is not infinite, assuming there areraised through common bonds. Partial euro bonds would convert signs of progress, ultimately implementation can probably takenational debt up to a certain share of GDP, the rest would be place over the next 18 to 36 months.issued nationally. Another potential approach is the “poolingproposal.” Under this approach, sovereign bonds would continue Unfortunately, the banking system is unlikely to have that luxury.to be issued separately, leaving sovereigns subject to market European banks have also benefited from the largess—in thediscipline. In addition to the regular sovereign bonds, a synthetic form of the long-term refinancing operation (LTRO)—of the ECB,security would be created with a safe tranche and a risky tranche. but they remain vulnerable. The risk to the European bankingThe safe tranche would help delink sovereign and banking risks.3 system is more acute and needs to be addressed in a much more compressed time frame.While economically logical, euro bonds still face significantpolitical obstacles. At its core, the concept entails countries with The good news is that the banks do not face the same liquidityless sovereign debt—Germany, Finland, Austria, the Nether- squeeze of a year ago. The ECB’s decision last December tolands—assuming now or in the future the liabilities of other provide unlimited collateralized loans for up to three yearscountries. Politicians in the north have become less viscerally afforded much-needed relief to the banks. As a result, short-termopposed to the idea, but it is clear that the concept will only work funding costs have fallen. There are also signs that bank fundingif the creditors can extract significant and binding constraints on conditions are easing, with debt issuance on the rise. But marketthe budgets of the more profligate countries.4 conditions are still far from normal, with indicators of bank credit risk persisting at high levels and with many institutions stillSome proposals that address the political economy dimension heavily reliant on central bank liquidity support.5 In other words,are those of the German Council of Economic Experts, or “Wise whatever improvement we’ve seen in bank liquidity can bemen,” (2011) and of Christian Hellwig and Thomas Philippon attributed almost entirely to the ECB. To the extent the LTRO will(2011). Both proposals preserve the political status quo and are eventually expire, banks will need a more permanent solution.compatible with the current EU Treaty’s no-bailout provisions. Theproposal of the German Council aims to reduce debt overhang by Of particular concern is what would happen in the event of an imminent and disorderly Greek exit. As discussed previously,1 Global Financial Stability Report, “The Quest for Lasting Stability,” IMF, April 2012, page 22. while the other peripheral countries face ongoing challenges,2 Ibid, page 56.3 Ibid, page 57. Greece’s large debt burden and ever-shrinking economy put it in4 Ibid, page 58. Ibid, page 28. 5
iSHARES MARKET PERSPECTIVES  a class by itself. Greece’s long-term viability as a member of the United States, at roughly 75%. The situation has left the euro remains in question. As long as that is the case, the risk of European banking system more exposed to structural and contagion is a very real threat. cyclical deleveraging pressure.7 As the ECB has been willing to dramatically alter the nature of its balance sheet, banks have If Greece were to leave the euro, Europeans would rationally been assured a source of liquidity—mostly through the LTRO question which country was next. This raises the risk that operation (see Figure 6). The ECB’s intervention has mitigated depositors in southern European countries would begin pulling much of the liquidity risk surrounding the European banking their funds from any bank domiciled in a country perceived as system, but bank capital levels remain too low. being at risk. While the ECB could theoretically step in to help plug the loss of retail funds, the central bank might find it Lender of Last Resort? difficult to stem the panic. In other words, as long as a euro in a There is now little doubt that the United States took a more Spanish or Italian bank is worth less than a euro in a German or effective approach in its stress tests and bank recapitalization Finnish bank, Europe is still vulnerable to an old-fashioned bank than did its European counterparts. While estimates vary, the run. Should Greece leave the euro in the near term, the contagion European banking system still needs several hundred billion risk is most acute through the banking channel. of new capital to stabilize the banking system. If an even worse recession is to be avoided, banks will need to improve their In order to remove these threats, there are several changes that capital adequacy through new equity rather than simply are needed, both for banks and their regulators. To start, banks deleveraging, which would only exacerbate an already painful must replenish their capital without simply delevering, their European recession. preferred approach to date. In addition, Europe must move much faster toward a common regulatory structure and some euro- In assessing next steps, Europe could probably do worse than wide mechanism to provide a basic level of deposit insurance. emulating the US approach. This would mean setting a new target for raising additional capital, and having the various EU On recapitalization, while European banks no longer have a countries, or the ESM if necessary, act as a backstop if the liquidity problem, they still have a solvency problem. The ECB banks were unable to raise the additional capital through must pay continued attention to funding needs of the banks, private investors. The European governments could pledge to but additional loss-absorbing capital is also needed, in line purchase equity in the major banks at a price discounted to with European Banking Authority (EBA) requirements.6 today’s market. This would effectively set a floor under the price, and hopefully give private investors the confidence to Although institutions in the United States have reduced their invest. Furthermore, any ECB bond purchase plan for a given leverage and reliance on wholesale funding, EU banks remain country could be made contingent on that country committing more reliant on wholesale funding, as opposed to retail deposits. to the bank recapitalization plan.8 Furthermore, though it is true that bank leverage has been reduced, levels remain elevated. In the eurozone, bank loan-to- In addition to recapitalizing the banks, Europe needs to deposit ratios are down from a peak of nearly 140% in 2008 to integrate its banking regulations and establish some form of around 125% today. This still compares unfavorably with the euro-wide deposit insurance. While there is broad agreement that the ECB will be the supranational regulator, there are lingering questions regarding which banks will be impacted. To date, the discussion is proceeding at an agonizingly slow pace.Figure 6: European Central Bank Balance Sheet(1999 to Present) Before Europe can put its financial system on firmer footing, there are a number of issues that still require resolution. First,ECB Balance Sheet (Billions Euros) 3500 there is considerable debate as to the timeline for establishing 3000 ECB-wide supervision. France and Italy are pressing for speedy 2500 implementation to get to burden sharing, but Germany seems to be dragging its heels. The current timeline has the ECB 2000 taking over supervision of the 17 systemically important 1500 financial institutions (SIFIs) in Europe in July 2013 and all 1000 banks in January 2014. 500 6 Ibid, page 21. 1/99 1/01 1/03 1/05 1/07 1/09 1/11 7 Ibid, page 38. 8 Philipp Hildebrand and Lee Sachs, “The Eurozone should fix its banks in the US way,” Source: Bloomberg, as of 8/31/12. Financial Times, September 25, 2012.
iSHARES MARKET PERSPECTIVES Beyond timing, there are also lingering issues regarding how the Figure 7 illustrates the extent of the challenge for southernEuropean institutions will provide supervision. The current European countries. As the figure illustrates, unit labor costs inproposal has the ECB Governing Council, which currently sets southern Europe have been rising at a much faster rate than ininterest rate policy, ultimately responsible for supervision. This the north of the continent. As a result, much of southern Europeraises awkward questions as to the ECB’s independence (would has lost its competitiveness with the northern part, particularlythe ECB wind down banks that it has previously given loans to Germany. One relatively painless way to address this would beand therefore would record losses on?). for Germany to allow its unit labor costs to rise faster. To the extent that southern Europe could hold its wage growth flat, thisThere is also the question of allocating responsibilities between would allow for a gradual adjustment. Unfortunately, as of today,those members of the EU that are in the euro versus those that inflation rates are actually higher in the south than in Germany.are not. The 10 non-eurozone countries, most vocally the United Given Germany’s historical aversion to inflation, faster wageKingdom and Sweden, are worried about the ECB’s supervisory growth may prove a tough sell.influence and the EBA’s powers to overrule national regulators.Even if non-euro EU states were to join the supervisory regime, Fortunately, southern Europe can also improve its competitive-rules currently prohibit them from voting on ECB decisions. ness through addressing structural impediments to growth. When looking at what ails southern Europe, Italy provides a veryLastly, there is the matter of how to assess contributions for the telling example. In some ways, Italy distinguishes itself frombank resolution fund and deposit guarantees; this is likely to Spain and other peripheral countries. While debt levels are high,become a political hot potato. One can only imagine trying to sell its deficit is low and the country is actually running a primary—to German voters their liability for Greek deposits. One recent before interest—surplus. Also, Italy enjoys a high level ofexample of the furor this may cause was outrage in Finnish papers national savings and hosts several world-class companies.months ago over just a suggestion of this. It is not hard to under-stand why this proposal, while necessary, will be so contentious. Nevertheless, while segments of the Italian economy functionEurozone bank deposits amount to some €15 trillion, of which quite well, overall Italy has many of the same structural flaws as€5.5 trillion are in Spain, Italy, Portugal and Ireland. the rest of southern Europe. Italian growth has averaged less than 0.5% in the last decade, while total factor productivityIn summary, this all suggests that the process will remain growth was negative.9politically contentious. We would expect continued headlinesover northern European opposition to burden sharing over the Weak growth can be attributed to a number of factors: regulatorycoming weeks and months, dampening stock market hopes for rigidities, labor market rigidities, and weak public services. Whilea speedy resolution. the new Italian technocratic government has implemented a number of necessary and important structural reforms, muchStructural Reforms: Growing Out of the Debt remains to be done. The existing reforms cover key structuralRequires GrowthAssuming the European Union can move toward closer fiscal andbanking integration, there is still a final hurdle that needs to be Figure 7: Eurozone Unit Labor Costsaddressed—growth. We said at the outset that the EuropeanUnion is solvent, at least communally. Aggregate sovereign debt 150of 85% is high, but manageable. Other countries have ap- Unit Labour Cost Indexproached similar levels—Canada in the early 1990s was a 140 (rebased to 100)notable example—and have successfully repaired their financ- 130es. But doing so will require not only a less fragile banking 120system and the pooling of resources, but also faster growth. Ifthe European Union can improve its secular growth rate, this will 110help make the debt burden more manageable in the same 100manner that faster income growth will alleviate the debt burden 90on US consumers. 2000 2002 2004 2006 2008 2010 2012 Greece Italy Portugal SpainHowever, achieving faster growth will require addressing Ireland France Germanyseveral labor market and other rigidities that have thus far Source: http://graphics.thomsonreuters.com/F/09/EUROZONE_REPORT2.htmlresisted all attempts at reform. In particular, southern Europe (accessed September 5, 2012).will need to regain its competitiveness and rein in its laborcosts (see Figure 7). 9 IMF Country Report No. 12/168, “Italy: Selected Issues,” July 2012, page 5.
iSHARES MARKET PERSPECTIVES bottlenecks in the product and labor markets, but the govern- All of these reforms will face some degree of resistance fromment has yet to address the sources of labor market rigidities. entrenched interests. Nevertheless, if southern Europe is toFuture reforms should aim to lower labor adjustment costs, manage its debt burden, that burden needs to be reducedintroduce more flexibility, increase participation—especially relative to national income. That will only happen if incomeamong women—and improve activation policies.10 grows faster, which is in turn dependent on removing the numerous barriers to growth. “Given our belief that the euro will survive, In the Meantime, Avoid the South but only after a prolonged transition toward Thanks in large part to the Herculean efforts and the unlimited balance sheet of the ECB, Europe has thus far avoided a crisis. The a fiscal union, we still prefer equities in the implementation of the OMT was a major step forward in reducing more stable north, especially Germany. We the systemic risks emanating from Europe. A further boost for eurozone equities was provided in early September by the remain underweight Spain and Italy, which German Constitutional Court ratifying the ESM. This buys we think are cheap for a reason.” time for the reforms described above. Given our belief that the euro will survive, but only after aIn addition to labor market rigidities, one of the main obstacles prolonged transition toward a fiscal union, we still prefer equitiesto growth is the public sector, which is grossly inefficient and too in the more stable north, especially Germany. We remain under-often an impediment to private sector initiative. Important areas weight Spain and Italy, which we think are cheap for a reason.for public sector reform include liberalization in the areas wherethe central government is a major stakeholder, liberalization and In arriving at these views, our methodology takes into accountincreasing competition in local services, and regional differentia- not only the valuation, but the fundamental and macroeconomiction and more flexibility in public sector employment and wages. factors that should drive the valuation, specifically economicIf done correctly, the impact of public sector reform could be growth, profitability, solvency and sentiment.sizeable. By adopting Organisation for Economic Co-operationand Development (OECD) best practices, Italy could raise real On these metrics, few European countries have a particularlyGDP by 5.75% after five years and by 10.5% in the long run.11 strong growth outlook. The only real exceptions are the NordicGiven the size of the Italian debt burden, a growth differential of countries—Sweden and Norway—which have, thus far, man-this magnitude could be a game changer for Italy, as well as aged to dodge the worst effects of the European recession.other southern European countries. Outside of the Nordics, the only real question is how bad the outlook is and how much of that is already reflected in the price.Another challenge throughout much of Europe is low labor forceparticipation. While this is also a growing issue in the UnitedStates where labor force participation is at a 31-year low, theproblem is even worse in much of Europe. For a 15- to 24-year-old Italian, the chance of being in education is about 60% and Figure 8: Near-Term Outlooks and the Factors Behind Them being employed is slightly more than 20%.12 For a 40- to 64-year- old, the chance of being employed is only 60% (mainly driven by Near-Term profit- risklow female employment) and being inactive about 35% (almost View p/b growth ability sentiment50% if a woman).13 Norway overweight + + +While the issue is long standing and does not lend itself to a Germany overweight – +quick solution, there are potential fixes. One would be to employ Netherlands overweight + –a method that has been extremely effective in Germany—pro- France neutral + – –moting apprenticeships. A second critical step would be to seek United Kingdom neutral – +to reduce the costs of individual dismissal by limiting compulsory Sweden neutral – + + +reinstatement in case of dismissal for economic reasons.14 Italy underweight + – – – Switzerland underweight – – +10 Ibid, page 6.11 Ibid. Spain underweight + – – –12 Ibid, page 12.13 Ibid, page 13.14 Ibid, page 12. Source: BlackRock MPS Group and Bloomberg, 9/25/12.
iSHARES MARKET PERSPECTIVES [ 10 ] Germany provides a good illustration. While we believe German growth Despite Herculean and unconventional efforts by the ECB, Europe’s will continue to fall, this appears fully reflected in the price of German long-term future remains very much in the balance. The acronym stocks. In assessing the near-term outlook for Germany, one indicator soup—SMP, LTRO, OMT—emanating from the ECB has helped prevent that has historically proved useful is the IFO Survey, a German business panic and dramatically lowered the risk of a liquidity crisis, but it sentiment measure. This measure has turned sharply lower in recent cannot solve the underlying structural problems that face Europe. months, falling from a high of 109.7 in April to 101.4 today (see Figure 9). However, while the drop confirms the slowdown we’ve seen in Those problems emanate from two sources: the incomplete nature German GDP, readings at this level are still close to the long-term of the European enterprise and structural rigidities that hamper average. This suggests that while the German economy may stall or growth. On the former, Europe must come together on some even suffer a mild contraction, as of now it looks to be a shallow one. mechanism to, at least partially, pool sovereign obligations. The monetary union needs to be complemented by some form of fiscal While German economic numbers are not yet signaling a severe union. In addition, the fragmented nature of the European banking recession, stocks prices are. German equities are trading well below system ensures that Europe’s banks will remain its Achilles’ heel. their historical valuations. Today, large-cap German stocks can be had In order to address this, Europe must agree to a realistic—note for roughly 10x forward earnings and 1.3x book value. In the past, the emphasis—recapitalization plan, rules for common banking German stocks have traded at approximately 1.7x book value, which regulation, and a euro-wide deposit insurance scheme. makes the current valuation a 25% discount to the long-term average. Longer term, Europe must simply grow faster. Given elevated debt It is true that given the prospects for weaker-than-normal growth, levels and deteriorating demographics, most of the developed world valuations should be lower, but the current discount appears faces a similar challenge. But most of southern Europe is further exaggerated. With the IFO at this level, you would expect German hampered by rigid labor markets and cosseted professions that equities to be trading at roughly 1.6x book value, rather than 1.3x. prevent competition and suffocate growth. This needs to be addressed. Obviously there are other factors driving the discount, not the least is the lingering sovereign debt and banking crisis. However, if the Given the nature of these reforms, they will require a concerted ECB has succeeded in mitigating this risk, it seems that valuations effort by politicians. Europe needs both institutional and structural at this level may offer an opportunity. The same holds true for other reform, which in many instances will necessitate a loss of sovereign- northern European countries as well. ty, a hard sell to countries that have been in existence for centuries. While there are economic solutions to Europe’s challenges, the Conclusion political changes will be slow, and investors are likely to be periodi- If you open up that Pandora’s Box, you never know what Trojan cally frustrated along the way. horses will jump out. –Ernest Bevin, warning on the consequences of setting up the That said, we do believe there is still a reasonable chance that Council of Europe Europe will manage this transition. It is helpful to remember that the motivation for the EU was never driven purely by economics, but had Mixed metaphor aside, the above quote has proved a prophetic its impetus in politics. European politicians recognized the factors warning. Europe is now confronting the implications of its initial that led to the catastrophe of two world wars. To their credit, the EU foray, more than 60 years ago, toward closer union. institutions have brought the continent closer. Hopefully, the political motivation will drive the further economic reforms that Europe desperately needs.Figure 9: IFO Pan German Business Climate Survey(1995 to Present) 120 However, even under a best-case scenario, these changes will take time. Given that Europe is likely to remain in a state of chronic stress 115 for a prolonged period, we would prefer to gain our EuropeanIFO Sentiment Survey 110 exposure primarily in northern Europe, as these countries appear 105 cheaper relative to their economic prospects. We would remain 100 underweight Europe, but maintain positions in Germany, the 95 Netherlands and Norway. As for taking on a more aggressive 90 position, particularly in southern Europe, that needs to wait for 85 evidence of either faster growth or a lower risk premium; both rest 80 in the hands of the politicians. 3/95 7/98 11/01 3/04 7/07 11/10 Source: Bloomberg, as of 9/26/12.