Reforms Help Revive Eurozone Recovery Hopes by Lisa F. Myers, CFA, Franklin Templeton Investments
Many of the eurozone’s local stock markets began 2015 with a bang, as the effects of the European Central Bank’s quantitative easing (QE) program were felt even before the bond-buying began. While QE seems to have provided a quick lift to many eurozone economies and and their respective equity markets, Lisa Myers, executive vice president, Templeton Global Equity Group™, stresses the importance of long-range structural reform in any sustained eurozone recovery. She analyzes country-specific endeavors and discusses their implications for future economic growth in the region.
Lisa F. Myers, CFA
Executive Vice President, Research Analyst
Templeton Global Equity Group™
Portfolio Manager, Templeton Global Balanced Fund
The European Central Bank (ECB) may have dragged its feet about announcing a quantitative easing (QE) program earlier this year, but it didn’t take long for the effects of QE to seep into the local economies and equity markets. In fact, before the €1.1 trillion program’s first bond was sold on March 9, the ECB upgraded its growth forecast for the region and eurozone stock indexes in general (and Germany’s DAX index in particular), had been performing well. It appears that low interest rates and a weakening currency—combined with a drop in oil price—already had started to trickle down to the economy, surprising many who thought the eurozone was down for the count.
While many pundits have focused on the seemingly fast-acting effects of QE, what hasn’t received a lot of attention, in our opinion, are the structural reforms that have been painstakingly enacted by a handful of eurozone countries, particularly Spain and Italy. In fact, Spain could be described as the poster child for the countries that have done a fair amount of the heavy lifting in terms of structural reform.
¡Viva la Reforma!
The progress we’ve seen in Spain as a leader among the peripheral eurozone countries has been, in our view, very much the result of the structural reform the country has undertaken. Economic growth resumed in Spain last year, and prospects for 2015 and 2016 appear to be on the rise.
Spain has enacted reforms that support the creation, survival and expansion of small to mid-sized business. For example, companies themselves now have more flexibility to set wages and working conditions rather than through sector-wide bargaining. The government also made it easier for Spanish companies to conduct business in different parts of the country. If a company meets the laws of a particular region, other regions can’t ask for additional requirements. The law is helping small and mid-sized businesses, which don’t typically have legal departments to advise them on how to expand their operations to other parts of the country. Goods and services lawfully produced in one region can be supplied to another region without being subject to any additional regulation.
Regarding tax policy, the Spanish government also has worked to shift the burden from payroll to consumption taxes, raising the value-added tax on products and services while lowering some income tax and social contributions.
Italy also has started to undertake serious reform measures, one of which may make obsolete an old joke that Italian employers can “divorce their spouses but not their employees.” Federal labor laws were recently changed to allow companies with more than 15 employees to lay off workers for the first time since 1970, when the government added worker protections beyond religious, sexual and ethnic discrimination.
Overall, the labor force in the eurozone has become increasingly temporary, which is clear evidence, in our opinion, that there is significantly more flexibility in the labor markets today than there was before. While the reforms enacted to date are a good start, significantly more can be done to increase flexibility.
Aggressive monetary policy and reduced fiscal drag from tapering austerity programs, together with structural reform should eventually translate into increased revenues and income for eurozone companies. Market expectations for an earnings recovery in Europe remain muted. Consensus 12-month forward earnings per share (EPS) estimates in the region are around 30% below earnings levels in 2008.1 Compare this to the United States, where consensus EPS estimates are around 25% higher than 2008 levels.2 Yet, the reforms that we are seeing in Europe right now are exactly the types of things needed to enhance structural profitability.
From a cyclical standpoint, Europe is still mired near the trough of a very depressed business cycle. However, as policymakers reform and stimulate with QE, we’re starting to see results. Credit growth (both on the supply and demand side) has been accelerating, consumer and investor confidence has been rising, and purchasing managers index (PMI) readings, which measure the health of the manufacturing sector, are at their highest levels since May 2011.3 So, we seem to be approaching a cyclical upswing at a time of significant structural improvements and powerful early-stage stimulus. All the pieces are in place; tellingly, we have recently seen earnings revisions (upgrades) approaching their highest levels on record in Europe.4
Dividends in the region are more than 30% above the global average, yet corporate free cash flow5 is being generated well in excess of these elevated payouts—at double the level of US corporates.6 And this is all occurring in a region that has very elevated operating leverage. In fact, if European profit margins were to recover to US levels, they would increase earnings by close to 50%.7 For all of these reasons, we believe the earnings recovery could be far more powerful than people expect. However, you wouldn’t know it from valuations.
Our strategy at Templeton Global Equity Group has traditionally been to invest where near-term expectations are low and other investors are ignoring the longer-term potential. We think the eurozone has the opportunity to rebound from a double-dip recession. The region had suffered through the financial crisis of 2007-2009 that began in the United States, and a subsequent sovereign debt crisis of its own. Now some headwinds seem to be turning to tailwinds. The combination of an earnings recovery and a valuation recovery leads us to believe there’s potentially healthy total return to be found in the eurozone for patient stock-pickers.
Lisa Myers’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.
This information is intended for US residents only.
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1. Source: Credit Suisse Research, March 2015. Earnings per share is a ratio that measures the amount of income earned per share of outstanding stock. Earnings per share is an indicator of a company’s profitability.
5. Free cash flow (FCF) represents the cash a company is able to generate after accounting for capital expenditures. FCF can be used for expansion, paying down debt, paying dividends or other purposes.
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