Europe is at a crossroads: Greece is about to receive its second bailout package, the ECB has pumped another €530bn into the economy and there is still little sign of growth. That’s not to say, however, that all hope is gone
As commentators and other interested parties pore over the details of Greece’s financial bailout package and consider the ramifications for the European economy at large, most observers will likely be taking a leaf out of Zhou Enlai’s book. When asked for his assessment of the French Revolution, the ex-Chinese Premier reportedly opined: “It’s too early to say.” Or so the story goes.
What is abundantly clear is that the €130bn rescue package will see the nation that gave birth to modern democracy reduced to colony status within the wider European ‘family’ and its working and middle classes condemned to years of financial servitude. For investors seeking opportunities in Europe, the debt swap package – put together by the so-called ‘troika’ comprised of the European Commission, International Money Fund and the ECB – carries two less-than-subtle messages:
1. A significant portion of the eurozone may not have been ‘open for business’ in recent years but the powers-that-be in Brussels will now be doing their utmost to (eventually) ensure it will, by lancing the Greek boil.
2. Eurozone members should know what to expect if they’re foolish enough to allow their domestic finances to deteriorate to anything remotely close to that of Greece.
If proof was ever needed, the chilling communiqué issued by the European Council immediately after the deal had been struck, sums it up. It reads in part:
“The Council today set out its position with a view to negotiations with the European Parliament on two draft regulations aimed at further strengthening economic governance in the euro area:
- A regulation for enhanced monitoring and assessment of draft budgetary plans of euro area member states, especially those subject to an excessive deficit procedure.
- A regulation on enhanced surveillance of euro area member states that are experiencing severe financial disturbance or request financial assistance.”
In shorter terms, no doubt uttered during some of the more heated debates in the council recently, if you don’t keep your financial house in order, you had better be prepared for someone to kick your front door down and come in and do it for you.
Becoming a subsidiary
The €130bn package requires Greece to cut its debt from 159.1 percent of GDP at present to 120.5 percent by 2020. Yet even before the ink had dried the troika was warning in a confidential document, subsequently leaked to the press, that Athens may need as much as €245bn to fund itself through to 2020 – this under a so-called ‘tailored downside scenario’ using assumptions that the Greek government fails to deliver needed structural reforms and policy adjustments leading to debt, as a proportion of GDP, remaining the same as now.
Private investors, meanwhile, will be swapping their existing bonds for new paper with a maturity of up to 30 years, having agreed to increase their nominal loss on existing holdings to 53.5 percent – equating to as much as 73 percent on a net present value (NPV) basis. The NPV loss represents the real loss suffered by investors as it takes into account factors such as future interest rates.
Athens has indicated it will pass legislation to enforce such haircuts on those bondholders not prepared to accept the bailout terms. In the meantime, €107bn of Greece’s debt will be written off. In addition, Greece will amend its constitution to give priority to debt repayments over the funding of government services. The government will also set up a special account, managed separately from its main budget, that must always contain sufficient money to service its debts for the coming three months.
In the wider context of eurozone debt exposure, recent analysis (via financial disclosures) from the New York Times showed five major US banks – J.P. Morgan Chase, Goldman Sachs, Bank of America, Citigroup and Morgan Stanley – collectively have $80bn worth of exposure to Italy, Spain, Portugal and Ireland, as well as Greece. Factoring in the use of credit default swaps (and other measures) to help them offset any losses that might occur if defaults swamped the five troubled nations, the banks have cut their theoretical exposure to $50bn – Citigroup having the greatest percentage of its exposure potentially protected at 47 percent, while Bank of America has bought the least protection at 12 percent.
Despite the doom and gloom in the run-up to the Greek deal and the likelihood that market sentiment won’t improve markedly in the short to medium term, given the eurozone economy as a whole is expected to remain flat, investment opportunities in Europe remain available – primarily in corporate bonds, distressed assets and real estate. The European corporate bond market, for example, has been showing significant strength in recent months. Indeed, bond mutual funds investing in corporate paper saw net inflows of €4bn in December – their highest since July 2011 – according to data from the European Fund and Asset Management Association (EFAMA).
In the capital markets meanwhile, the Greek deal had an immediate impact on German steelmaker ThyssenKrupp and Swedish security services group Securitas who saw combined demand of almost €10bn from investors for their paper – ThyssenKrupp’s €1.25bn five-year issue attracting more than €7.5bn of orders with Securitas registering demand in excess of €2bn for its €350m, five-year offering.
Underpinning the corporate bond market has been the Basel III capital adequacy directive requiring banks to bolster their capital reserves, which in turn has led to them increasingly hoarding cash.
Consequently, they’ve been tightening up their lending criteria, forcing businesses to seek alternative sources of financing. Borrowers are also being tempted by bonds over loans because of favourable coupon rates, underlying liquidity in the bond market and the prospect of deals being closed more quickly.
Strength in bonds
Tighter lending criteria on the part of the banks has merely reinforced the original suspicion that the ECB’s €489bn Long Term Refinancing Operation (LTRO) announced in December – aimed at encouraging banks to increase lending to businesses – has had little overall impact so far. Indeed, the evidence suggests the 523 banks taking up the ECB’s offer of swapping cheaper three-year loans in exchange for existing (and more expensive) short-term ones has merely led to the repayment of the latter to the ECB – the balance finding its way back to the central bank on deposit.
Figures from data provider, Dealogic, show euro-denominated corporate bond issuance hitting €42.2bn in the January-February 2012 period; compared to €23.16bn in the corresponding period in 2011. It was also the highest since a record €71.3bn in Jan-Feb 2009. Putting this into even sharper relief, the number of euro-denominated corporate bond issues stood at 75, the highest since the 76 seen in January-February 2001. German issuers have led the pack with €10.5bn of bonds sold, accounting for one quarter of all euro-denominated corporate debt in 2012 (through end-February) – up sharply from the 14 percent share seen 12 months ago. UK-based issuers of euro-denominated bonds have raised €5.34bn.
Issuance hasn’t been confined to companies based in the stable economic core of Europe – such as Germany – though Enel, Italy’s biggest utility, did offer a €3bn, two-part retail bond due in 2018 which subsequently attracted more than €5bn in demand with yields set at the bottom end of the range it had previously indicated. A €2.5bn fixed-rate tranche was priced to yield 4.885 percent, while a €500m euro floating-rate tranche was set at 310 basis points above the six-month Euribor rate. Enel, which has €10bn of debt maturing in 2012, has already secured funding for €7.5bn.
As the eurozone debt crisis has unfolded US (and other) investors have been looking to snap up assets owned by European banks forced to raise additional capital and shrink their balance sheets. And with Europe’s banks forecast to unload between $2.5trn and $3trn worth of assets over the next 18 months this trend is expected to continue.
In 2011, for example, Google bought the Montevetro building in Dublin – the city of its European headquarters – from Ireland’s National Asset Management Agency, which acquired it after a huge bank rescue by the government there. US hedge funds and private equity firms, have becoming increasingly active, given distressed bank assets can offer high real returns for those with the necessary risk appetite. And hedge funds most certainly do.
Strategic Value Partners, the hedge fund firm founded by Merrill Lynch veteran, Victor Khosla, is a case in point – the company recently confirming its Strategic Value Special Situations Fund II – set to focus on distressed assets in Europe – had raised $918m having set an original target of $600m. Investments will focus on senior debt higher up the food chain, as well as some bank debt and other loans. Returns on investments are expected to be generated over a two to three-year period, rather than on shorter-term trades.
Even more risk conscious investors, such as insurers, have been quietly looking at longer-term assets such as high quality loan books, as and when they become available. Such a general upsurge in activity in this market isn’t difficult to understand, however. Back in September 2011 France’s BNP Paribas announced plans to sell €70bn of assets including loans, while Germany’s second largest lender Commerzbank has indicated it could reduce it its risk weighted assets by as much as €30bn by mid-2012 in order to meet European Banking Authority (EBA) requirements on capital. Elsewhere, Italy’s UniCredit has earmarked €48bn worth of non-core assets to be either sold or run off over the next few years.
European banks are already on a fast-track deleveraging drive to raise €114.7bn of extra capital by mid 2012 as they look to meet the EBA requirements. Unlike the US, where an infusion of liquidity from the Fed created a relatively quick V-shaped domestic economic recovery, the timeframe in Europe for banks to offload non-core assets is more likely to stretch to three-to-five years as the continent continues to see below trend growth. This is being reinforced by the slower-than-expected pace European banks have been offloading their assets. Despite being under pressure to recapitalise many have been reluctant to purge assets at the steep discounts on offer.
In the real estate sector we may not be living in boom times but the investment case, especially when compared to most other sectors, may yet become a persuasive one over the long term. In its report: ‘A New World of Cities – Redefining the Real Estate Investment Map’ – Jones Lang LaSalle, the global real estate services firm, noted that 50 percent of global commercial real estate investment in 2010-11 was still concentrated in just 30 ‘high-order’ cities. Of these the top five – London, Tokyo, New York, Hong Kong and Paris – accounted for nearly one-quarter of investment volumes.
By 2020, the ‘top 30’ is more likely to become a ‘top 50’ as cities such as Mexico City, Delhi and Istanbul join the top echelons of investible cities. However, the current dominance of the top five is only likely to slowly erode over time. Looking at Europe more specifically the investment outlook in 2012 for prime offices, retail and industrial property remains positive with increased demand expected across selected European cities, coupled with modest rental growth, according to Jones Lang LaSalle. But 2012 will not be a vintage year.In Q4 2011 direct commercial real estate investment amounted to $106.2bn globally, up four percent on Q3. A strong end to the year in Europe in particular ensured 2011 as a whole ended 28 percent higher than 2010 at $410.6bn. Cross border purchases as a proportion of the total remained stable between the quarters at 30 percent. However, on an annual basis investors proved more bullish, increasing the level of cross border purchasing activity from 27 percent in 2010 to 31 percent in 2011. At the heart of this change was an increased focus on core, developed markets at the expense of potential opportunities in developing countries.
As inter-regional investment into the Asia Pacific region fell, the Americas and Europe benefitted most from the increase in activity in 2011 – the retail sector especially evident in both regions. Volumes in Europe rose almost 20 percent year-on-year with retail acquisitions (up 40+ percent) surging at the expense of mixed use schemes. Despite the financial crisis the continued weight of money behind commercial property acquisitions demonstrates it remains a core asset class for many investors. In a February note, Andrew Burrell, Head of Forecasting – EMEA, at Jones Lang LaSalle, said that while the ECB’s emergency loans (LTRO) initiative back in December had probably averted another credit crunch in Europe, the weakest EU banks remain on life support.
In the meantime – the Greek deal aside – Portugal looks like a slow motion replay. And with still no firewall to protect Spain and Italy, the underlying situation, although no worse than 2011, certainly isn’t decisively better either, says Burrell. On balance, the time has come to be cautiously optimistic and consideration should be given for upside in the real estate sector. But it is still far too early to call an end to the danger in the eurozone, given the possibility of the crisis flaring up again.
Stocks and shares
If the case can be made for corporate bonds, distressed assets and to a lesser extent, commercial property, equities present more of a conundrum. US (and other) investors looking for opportunities in Europe should consider stock and sector selection, given analysts have continued to downgrade their corporate earnings expectations for European companies, due to persisting economic uncertainty across the continent, according to S&P Capital IQ.
The company polls individual equity analysts for their corporate earnings forecasts and then calculates an analyst mean estimate for each corporation included in the S&P Europe 350 Index – that index including corporations domiciled in 17 major European markets, covering approximately 70 percent of the region’s market capitalisation. As of end-January, according to S&P Capital IQ, sector leaders for calendar-year 2012 earnings included the financials (23.02 percent expected earnings growth) and industrials (13.40 percent expected growth) sectors.
Current earnings laggards include the information technology (forecast decline of 9.46 percent) and healthcare (0.51 percent expected growth) sectors. Mixed financial results in January from a number of companies resulted in analysts cutting 2012 and 2013 earnings estimates for the information technology sector by nine percent and four percent, respectively – the largest cut of all 10 sectors monitored by S&P.
French-Italian semiconductor manufacturer, STMicroelectronics said revenue will decline as much as 10 percent from the previous three months on lower wireless sales, while Swedish telecommunications systems manufacturer Ericsson reported a 73 percent drop in Q4 net profits to 1.15 billion kronor ($168m) on lower spending from North American customers.
While Nokia Corporation reported better-than-expected Q4 numbers, analysts still lowered their earnings estimates for the Finnish company as it continues to struggle to compete in the smartphone market. German software giant SAP AG also posted good numbers, although estimates here were trimmed too on expectations of slowing global growth. This came despite the company claiming it can grow revenues by at least 10 percent a year, even without acquisitions. While the domestic demand outlook for Europe is weak, US asset manager BlackRock notes that over 50 percent of European corporate earnings now come from outside the euro area.
The waiting game
During 2011, the euro/dollar rate peaked at 1.48, fell below 1.27 at the beginning of the year and has since been trading in the 1.32 area. Assuming the currency remains relatively weak against the dollar, this should provide some support to European earnings much in the same way US earnings benefitted from a weaker dollar in 2011. While valuation is never enough to support a stock or market in the short term, on a long-term view it can offer significant opportunities.
“Europe continues to offer the cheapest valuations of all the developed equity regions and we believe that the current valuation levels, driven by euro crisis risk aversion, provide attractive entry levels for long-term investors who are prepared to tolerate shorter-term volatility,” the company said in a recent and somewhat complementary note.
The obvious risk is that the euro area crisis spins much further out of control, plunging the continent into a deep recession and taking the rest of the world down with it. A more likely outcome however, is that progress made within and by the ECB, via support to the banking sector and a real delivery of policies by politicians to address the heart of the euro sovereign debt crisis, will reduce this negative tail risk.
Based on a flat earnings outcome for 2012 the market is on a price/earnings ratio of 10.7x, according to BlackRock – at the low end of its long-term range. The company is maintaining a keen eye on valuation levels, given much of the market is still very much defensively positioned. And while it continues to pick up good companies that have reached oversold levels, market returns for the year are likely to remain volatile in the short-term at least.
If there is a resolution to the sovereign debt crisis, the reduction in the risk premium could allow a re-rating of European equities, despite the flat earnings outlook in 2012.
“In such an environment a re-rating of the market to a price/earnings ratio of 12.5x is entirely feasible. Coupled with a four percent yield, this would provide a 20 percent total return from current levels. However, it is dependent on the politicians providing the correct long-term framework for the eurozone, which will give investors the confidence to return to European equities,” it concluded.
Data from the OECD – regarding growth prospects – reflect the ongoing uncertainty. The international economic outlook may be showing tentative signs of improvement, yet much like the curate’s egg, the picture remains mixed in the eurozone where the region’s overall rating dipped marginally.
If the only certainty in Europe at present is uncertainty, investors should not necessarily be too dismissive, especially those with sufficient risk appetite to stay in for the long haul.
They may eventually reap handsome returns, even among equities.