On Europe

30 Jan 2015

By Stuart Mitchell

The advent of quantitative easing (QE) in the eurozone, and the victory of Syriza at the Greek elections last weekend are clearly important events but their significance should not be mistaken.

Instead of reflecting an existential challenge to the whole ‘European project’, they should, rather, be seen as milestones on the long path towards the return of the eurozone to economic normality. What is more, the end of that path, after the seven long years since the financial crisis broke, is now easier to discern.

The challenge for policy makers in the eurozone has been to preserve the goal of a more integrated Europe, and at the same time to ensure that the more profligate countries at the periphery learn to control their finances more carefully, and make their corporate sectors more competitive. Why should the Germans and French underwrite the debts of countries that continue to threaten to default because local politicians did not have the stomach to push through reforms?

The arrival of QE is, in effect, an acknowledgement by core Europe that the periphery has reformed sufficiently that the underwriting of peripheral debt can now, at long last, be contemplated. The ECB – which is to say the eurozone – will underwrite 20% of the bonds purchase, a key staging post in the move towards full debt mutualisation across the eurozone. It is being recognized how much the challenged peripheral countries have done to bring their houses into order. Spain, Portugal, Ireland and Greece have all gone through unimaginable austerity; their economies are now growing again, and they are running healthy current account surpluses. The efforts made by the corporate sector have been remarkable. Just look at the job and salary cuts at Iberia, or the deep job cuts across the banking industry. Even the most ostentatiously fiscally conservative Germans seem privately readier to underwrite the debts of the eurozone.

But what about the victory of Syriza, with its rejectionist platform, in the Greek elections? As we write, only one thing is certain: it is inevitable that some amount of Greek debt will have to be forgiven. The only debate is how this is dressed up. We are probably somewhere near the point where Syriza’s demands can be accepted and the Greek recovery, already under way, be allowed to continue. With the European Investment Bank now proposing to sponsor €315bn of infrastructure spending, we are getting close to a significant fiscal boost for the region as a whole, on top of the ECB’s monetary boost. We may well be approaching a lasting resolution to the eurozone crisis.

This all creates an extraordinary opportunity for investing in the eurozone. Consensus expectations remain framed by fears of a ‘euro crisis’, and valuations are low. So low, in fact, that on one calculation, current share prices can be justified only if you accept the notion that half of European companies will suffer declining returns on capital employed into perpetuity, a clearly absurd assumption. The average domestically orientated European company trades at a 50% discount to its US counterpart.

Credit conditions are improving across the region. QE, and other monetary operations are bearing down on bank funding costs, most notably in the periphery of Europe. The growth in money supply, also, appears to be gathering momentum, with a recent ECB bank lending survey showing the strongest pick up in credit demand since 2007. The results of the Asset Quality Review suggest that the financial system is better capitalized than many had thought.

Finally, the recent sharp fall – 15% – in the value of the euro relative to the US dollar should significantly stimulate growth, while the even steeper fall in the oil price will likewise help: oil at $50 a barrel probably adds ½% to 1% to annual European economic growth.

Consensus remains convinced that the outlook for Europe remains dire. We disagree. This is not the beginning of the end. It is the end of the beginning. We remain committed to more Europe-centered, domestically orientated, companies, which now constitute almost two thirds of our investments, whilst companies from that object of consensus-investor concern, the European periphery, now represent nearly a quarter of our holdings.

Stuart Mitchell is manager of the SWMC European Fund and founder of SW Mitchell Capital

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