Grounds for optimism in Europe

Despite European woes, there are some positive signs; the private sector’s improved balance sheet, clarity on regulation and America’s recovery will all help towards investment growth.

Nick Judge
Nick Judge, GLG UK Equity

In Europe, the three-year Long-Term Refinancing Operation (LTRO) operation by Mario Draghi’s European Central Bank (ECB) is a key policy development. As a result we have observed direct and meaningful improvements to credit markets, namely that its focus will move on to more analysable and tradable themes. There is still more to watch from the politicians and policy makers, but we suspect a lower euro is part of the solution, rather than the problem.

On the other hand, markets are increasingly focusing on deflation risk. Indeed, since May, American 10-year bond yields have fallen from 3.10% to a low of sub-1.80%. In many cases financial stocks traded at 30% of book value, with European concerns putting the asset side of banks balance sheets under question. Cyclical companies now experience concurrent price/earnings (P/E) and consensus earnings downgrades, leading to the situation where you have been able to buy companies at the bottom of their earnings and P/E cycle.

This presents chief executives with a challenge. While the 2008 play book for investors was to delever, the lesson for chief executives of FTSE 100 companies (those with great cash flow) was to go shopping to buy assets. This pressure is even more potent now, as long-term interest rates are much lower and inflation rates higher, making attractively-priced free cash flow even more attractive relative to cash.

The FTSE 100 is particularly well positioned for global growth driven from America, with only 15% of the indexes sales going to Europe. Again, there is a strong case for the stocks with the strongest balance sheets to increase returns to shareholders from a combination of buy-backs and increasing dividends; and despite yielding 4%, the pay-out ratio has been falling (39% for 2011, despite record free cash flow cover, low debt/ebitda and debt/equity). This has been a virtuous place for these stocks as dividends announcements have, historically, led the next 12 months earnings momentum. British buy-backs will be higher than 2% of market cap (versus 0.6% in 2010 and 1% in 2011 – greater than any of the past 10 years). (Trends continues below)

A recovery in the cyclical parts of the American economy can have a transformational effect on getting the global economy to lift-off speed. According to the Bureau of Economic Analysis, the percentage of GDP invested in durable goods and fixed asset investment is still around its post-second world war lows. This can be seen in a rapidly-aging capital stock, especially in areas like the auto fleet, which has an average age of 11.6 years; Indeed, the past three years are the only years on record that scrappage exceeded sales. Normally these cyclical parts of the economy would be the catalyst for a recession as activity falls off from high levels, but this is now mathematically difficult to do as we are running close to levels of activity that barely, if at all, cover replacement levels.

”A recovery in the cyclical parts of the American economy can have a transformational effect on getting the global economy to lift-off speed”

While auto sales, large durable goods and corporate capital expenditure are important parts of this mix, the key asset that needs to show signs of life is housing. The multiplier on housing is so powerful that the lacklustre recovery in job creation can be understood in the context of record lows in housing starts. Indeed, each additional start would add 3.5 jobs to national payrolls, so a recovery to the long-term average of 1.3m starts (from approx 500,000 at the trough) would add 2.7m private sector jobs to the economy.

Interesting, also, are the knock-on benefits. A study by the Department of Housing and Urban Development shows that the average buyer of a new home spends $5,000 in the first year. There is also the significant wealth effect. While in 2008 households were hit with rising energy prices and falling home and equity prices, looking forward the already depressed levels of house prices can do little further damage to household expenditure. For the first time since 1981 median monthly mortgage payments are lower than rents, and with 30-year fixed rate mortgages available sub-4%, affordability is as attractive as it has ever been at 2.7x income.

We have observed a steady loosening in conditions, with recent data showing 80% of new mortgages applications being approved. Significantly, almost all measures of house prices are starting to move up, and there are both positive wealth effects and consumer confidence.

Regulation, particularly in the financial sector, has impacted the extension of credit to all parts of the economy. We are finally encouraged that policymakers on both sides of the Atlantic are acknowledging that the banking system is the key transmission mechanism for policy into the economy. But while interpretation of mountains of new regulation is still pending, lenders are unable to flex their balance sheets. Be it Dodd-Frank, the Volker rule, Basle III or the IBC, there is a shortage of clarity; however, we feel we have passed the point of maximum uncertainty.

Indeed, we think the criteria we identified 12 months ago are now more strongly entrenched to support strong performance; an acceleration in both the demand for and the extension of credit; improving economic tailwinds; and policy makers and regulators removing some of the uncertainty that has hung heavy over the financial sector for some time.

We anticipate some powerful tailwinds to global growth to come out of developed markets, especially from America. With much of the private sector balance sheet repair having been achieved and key assets bottoming, we expect levels of investment to grow from depressed levels and clarity on regulation to free up capital. With large sales to America, a valuation gap with the relative P/E to the S&P 500 at distressed levels and accommodative monetary policy – implying the highest equity risk premium in developed markets – the British stockmarket offers attractive opportunities to profit from healthy American economic growth. While we remain vigilant about Europe’s woes, we are compelled to admire the nascent recovery occurring in America. A phenomenon which, if continues, could easily provide a floor to Europe’s problems.