Eurozone Crisis Report Card

Ryan DresselRyan Dressel, Investment Analyst, Brinker Capital

In January 2013 Amy Magnotta wrote in detail about how the actions of the European Central Bank (ECB) finally gave the markets confidence that policy makers could get their sovereign debt problems under control.[1] The purpose of this blog is to measure the progress of the ECB’s actions, as well as other critical steps taken to resolve the Eurozone crisis.

Maintaining the Euro: A+
The markets put a lot of faith in the comments made by the head of the ECB Mario Draghi in July, 2012. Draghi stated that he would “Pledge to do whatever it takes to preserve the euro.” These words have proven to be monumental in preserving the euro as a currency. Following his announcement, the ECB still had to put together a plan that would be approved by the ECB’s governing council (comprised of banking representatives from each of the 18 EU countries)[2]. The politics of the approval essentially boiled down to whether or not each council member supported the euro as a currency. Draghi’s plan ultimately passed when Germany’s Chancellor, Angela Merkel, endorsed it in September 2012.[3] The stabilization of the euro boosted lending and borrowing for European banks, and allowed governments to introduce necessary economic reforms outlined in the plan.

Since the plan was approved, the euro’s value versus the U.S. Dollar has continued to rise; reaching levels last seen in 2011. There is still some debate as to whether or not the currency will last over the long term, but for now its stability has helped avoid the worst possible outcome (financial collapse). There are several key elections coming up over the next month, which could renew the threat of breaking up the currency if anti-EU officials are elected.

Government Deficit Levels: B
The average Eurozone government deficit came in at 3.0% in 2013, which was down from 3.7% in 2012. Budgets will need to remain tight for years to come.

Corporate Earnings: B
The MSCI Europe All Cap Index has returned 27.46% in 2013 and 5.01% so far in 2014 (as of last week). The Euro area also recorded first quarter 2014 GDP growth at +0.2% (-1.2% in Q1 2013).[4] This indicates that companies in Europe have established some positive earnings growth since the peak of the crisis. On a global scale, Europe looks like an attractive market for growth.

Dressel_EuroZone_ReportCard_5.30.14

Unemployment: C
Unemployment in the Eurozone has stabilized, but has not improved significantly enough to overcome its structural problems. The best improvements have come out of Spain, Ireland and Portugal due to a variety of reasons. In Ireland, emigration has helped reduce jobless claims while a majority of economic sectors increased employment growth. In Spain, the increased competitiveness in the manufacturing sector has been a large contributor. Portugal has seen a broad reduction in unemployment stemming from the strict labor reforms mandated by the ECB in exchange for bailout packages. These reforms are increasing worker hours, cutting overtime payments, reducing holidays, and giving companies the ability to replace poorly performing employees.[5]

Dressel_EuroZone_ReportCard_5.30.14_1[6]

There are also some important fundamental factors detracting from the overall labor market recovery. The large divide between temporary workers and permanent workers in many Eurozone countries has made labor markets especially difficult to reform. This is likely due to a mismatch of skills between employers and workers. High employment taxes and conservative decision-making by local governments and corporations have also created challenges for the recovery.

Additional Reading: Euro Area Labor Markets

Debt Levels: D
Total accumulated public debt in the Eurozone has actually gotten worse since the ECB’s plan was introduced. In 2013 it was 92.6% of gross domestic product, up from 90.7% in 2012. The stated European Union limit is 60%, which reflects the extremely high amount of government borrowing required to stabilize their economies.

Overall Recovery Progress: B-
On a positive note, governments are finally able to participate in bond markets without the fear of bankruptcy looming. Banks are lending again. Unemployment appears to have peaked and political officials recognize the importance of improving economic progress.

Unlike the 2008 U.S. recovery however, progress is noticeably slower. The social unrest, slow decision making, low confidence levels, and now geopolitical risks in Ukraine have hampered the recovery. When you consider the financial state of Europe less than two years ago, you have to give the ECB, and Europe in general, some credit. Things are slowly heading in the right direction.

The views expressed are those of Brinker Capital and are for informational purposes only. Holdings are subject to change.

[1] January 4, 2013. “Is Europe on the Mend?” http://blog.brinkercapital.com/2013/01/04/is-europe-on-the-mend/
[2]
European Central Bank. http://www.ecb.europa.eu/ecb/orga/decisions/govc/html/index.en.html
[3] September 6, 2012. “Technical features of Outright Monetary Transactions. European Central Bank.” http://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html
[4] Eurostat
[5] August 6, 2012. “Portugal Enforces Labour Reforms but More Demanded.” http://www.wsws.org/en/articles/2012/08/port-a06.html
[6] Eurostat (provided by Google Public Data)

Investment Insights Podcast – Unrest in Ukraine and Investment Implications

Stuart Quint, Investment Insights PodcastStuart P. Quint, CFA, Senior Investment Manager and International Strategist

Stuart joins us this week to share some comments on the developing situation in Ukraine and its impact on investors.  Click the play button below to listen in to his podcast, or read a summarized version of his thoughts below.

Podcast recorded March 3, 2014:

Ukraine’s struggles are overwhelming. Political, economic, and now military challenges confront the country. Politically and militarily speaking, the U.S. and the European Union (EU) have few tools at this time and modest willpower to oppose Russian intentions in Ukraine. And given that the ruling government is merely a caretaker for the May elections, it seems unlikely there will be a bailout package offered by the International Money Fund (IMF) any time soon. Default on existing international and local obligations appears likely in the near term.

Russia is not without its own constraints, though, as the Russian economy is directly tied to Europe. Three out of every four dollars of foreign direct investment in Russia come from Europe.[1]  The EU also remains Russia’s most important trading partner with 55% of Russian exports destined for Europe.[2]

Let’s take a look at the potential scenarios: (1) Russian annexation of the Crimea, (2) negotiated settlement with later elections that would most likely bring about a grand coalition government, probably with leanings toward Moscow, and (3) military escalation (civil war, Russian forces occupy eastern Ukraine, either of which results in a smaller Ukraine or outright disintegration as a sovereign state).

So what investment implications might this have? (1) The near term is helpful for fixed income, with commodities benefiting from any disruption of supply (oil, gas) and flight to safety (gold), and (2) negative impact most of all for European (Russia supplies 30% of European gas supply[3]) and emerging markets (mainly Russia, but also other markets with the need to import capital could suffer from currency weakness and higher interest rates demanded by investors).

A negotiated settlement involving recognition of Russian claims in exchange for a roadmap to stabilize the rest of Ukraine would reverse many of these trends.  Indeed, a similar situation occurred when Russia invaded Georgia in August 2008, but the crisis in Ukraine has potentially more serious implications given its proximity to Western Europe and that it carries a large population of over 45 million people.[4]

The views expressed are those of Brinker Capital and are for informational purposes only. Holdings are subject to change.

There’s a Reason It’s Cheap

Jeff RauppJeff Raupp, CFA, Senior Investment Manager

A few years ago when I was down the shore in New Jersey with my family, I decided it was time for my then nine- and six-year-old children to try one of my favorite childhood pastimes—boogie boarding. For those unfamiliar, a boogie board is a (very) poor-man’s version of a surf board; basically a short board that helps you ride waves either on your stomach or, if you’re really good, your knees. So we went to the store to buy a pair of boards and found a pretty wide price range— $10 for the 26-inch, all-foam board to $100+ for the 42-inch poly-something-or-other board with the hard-slick bottom. Being a bit of a value investor, and not knowing how much the kids would like riding waves, I went with something much closer to the bottom end of that range. To make a long story short, three hours later I found myself with a broken board (who knew a foam board couldn’t handle a 200+ lb dad demonstrating?), a broken ego, and a trip back to the store to purchase a new pair of boards—this time closer to the middle of the price range. A good lesson for the kids, but definitely a reinforced lesson for me, is often when something is cheap there’s a very good reason why.

8.22.13_Raupp_Cheap_1I’m reminded of this lesson when I look at global equity valuations, particularly those in Europe. Forward P/E ratios (stock price divided by the next 12 months of projected earnings) in most of the major Eurozone countries fall in the 10- to 12-times range, which is relatively cheap from a historical perspective. Compared to the U.S. at 14½ and other developed countries like Japan and Australia at close to 14, the region seems pretty attractive. Tack onto that that the Eurozone has just emerged from its longest recession ever, and the idea that markets are forward-looking, it would seem like a great opportunity to rotate assets into cheap markets as their economies are improving. And we’re seeing some of that in the third quarter, as the Europe-heavy MSCI EAFE index has outpaced the S&P 500 by about 3% quarter-to-date.

But, similar to low-priced boogie boards, buyers of European equities need to be aware of the risks that come with your “bargain” purchase. This past Tuesday, German finance minister, Wolfgang Schauble, admitted that there would need to be another Greek bailout next year even though they’ve been bailed out twice in the last four years and restructured (defaulted on) 25% of their debt in 2012. All told, about $500 billion has gone to support an economy with a 2013 GDP of about $250 billion, and it hasn’t been enough. And by the way, youth unemployment is approaching 60%, and 2013 has seen multiple protests and strikes over austerity measures.

8.22.13_Raupp_Cheap_2Beyond Greece, Portugal and Ireland are running national debts of over 120% of GDP and could need additional bailout money. Italy is operating with a divided government and a national debt of over 130% of GDP, and the Netherlands and Spain are still on the downward side of the housing bubble. Germany has been Europe’s economic powerhouse and has played an integral role in containing the debt issues on Europe’s southern periphery. But they’ve been grudging financiers, so much so that German chancellor Angela Merkel has gone to great lengths to avoid the topic of additional bailouts ahead of upcoming German elections.

Sometimes that bargain purchase works out. You get the right product on sale or you’re able to buy cheap markets when the negatives have already been baked into the price. But make sure you’re considering all the angles, or you could quickly end up back at the store.

Trouble in the Mediterranean

Joe PreisserJoe Preisser, Investment Strategist, Brinker Capital

Blue-chip stocks listed in the United States stumbled on their quest to reclaim the historic heights they recently attained, as a renewal of concerns from the European continent served to unsettle investors. Proverbial wisdom contends that markets will climb a, “wall of worry”, and this statement has rung particularly true this year as the Dow Jones Industrial Average has marched steadily higher amid a torrent of potential pitfalls. Up until this week, market participants have largely disregarded the political gridlock ensnaring Washington, D.C. and the possibility of a resurgence of the European sovereign debt crisis, instead clamoring for risk assets, and in so doing, have driven stocks into record territory. The current rally has, however, paused for the moment with the increased possibility that Cyprus may become the first member of the Eurozone to exit the currency union, once again casting the shadow of doubt across the Mediterranean Sea and onto the sustainability of this collection of countries.

A decision rendered by leaders of the European Union last weekend—to attempt to impose a tax on bank deposits within the nation of Cyprus in exchange for the release of rescue funds the country desperately needs—sent tremors through global financial markets. Although the Cypriot population stands at slightly more than one million citizens, making it one of the smallest countries in the Eurozone, the repercussions of this decision were felt across continents. Policy makers representing the nations of their monetary union hastily gathered to decide what conditions would need to be met in order to disperse the necessary financial aid to Cyprus, totaling ten billion euros, and in so doing, made a significant policy error. According to The New York Times on March 19, “Under the terms of Cyprus’ bailout, the government must raise 5.8 billion euros by levying a one-time tax of 9.9 percent on depositors with balances of more than 100,000 euros. Those with balances below that threshold would pay 6.75 percent, an asset tax that would still hit pensioners and the lowest -income earners hard.” Although the intentions of the European leaders making this decision were to target large foreign depositors, who have historically used the country’s banks as a tax haven, the proposed inclusion of those on the lower end of the spectrum has created widespread uncertainty.

EurosThe imposition of a tax on deposits that would include those of 100,000 euros and less, which had been guaranteed by insurance provided by the European Union, has created concerns over the stability of the banking system in Cyprus and by extension, that of the Eurozone in its entirety. By negating the very guarantee that had been put in place to strengthen this vital portion of the Eurozone’s financial system, policy makers have increased the risk that large scale withdrawals will be taken across Cyprus, which is exactly the type of situation they had hoped to avoid. The New York Times quoted Andreas Andreou, a 26-year-old employee of a Cypriot trading company, who gave voice to the feelings of the populace when he said, “How can I trust any bank in the Eurozone after this decision? I’m lifting all my deposits as soon as the banks open. I’d rather put the money in my mattress.” In order to forestall such an event, and protect against the possibility of contagion to the other heavily indebted members of the currency union, the country’s banks have been shuttered and are scheduled to remain so until Tuesday.

Uncertainty continues to swirl in the warm Mediterranean air as the Cypriot Parliament on Wednesday rejected the original terms of the bailout, casting the nation’s leaders into direct conflict with those of the European Union. With the deadline for
the country to propose a viable plan to raise the requisite 5.8 billion euros,
set by the Continent’s Central Bank for Monday, fast approaching, the stakes of
this game of brinksmanship have been raised, as the possibility of the country
leaving the euro zone has been broached. Eric Dor, a French economist who is the head of research at the Iéseg School of Management in Lille, France offered his opinion on the rationale of Europe’s leaders in The New York Times on Thursday, “They are saying we can take the risk of pushing Cyprus out of the Eurozone, and that Europe can take the losses without going broke.” Although the raising of the possibility of Cyprus being expelled from the monetary union, is most likely a negotiating tactic designed to goad Cypriot leaders into adopting the reforms the E.U. has deemed necessary, with the more likely outcome of a compromise being reached, the current impasse serves as a reminder of the difficulties facing the Continent as it continues its unprecedented experiment in democracy.