Byron Wien: A Reluctant Europe Looks at Prosperity
The mood among investors in Europe is generally positive in spite of mixed cyclical and secular factors influencing the economies and the markets there. The cyclical forces are dominated by a better business tone across the continent. The secular factors are the spread of populism as a result of governments not providing opportunity for the people, and terrorism, which can erupt almost everywhere and cannot be controlled. The secular factors will eventually affect spending and investment, but so far the data are coming in better than expected, and Europe should have real growth of 1.7% this year. Even the United Kingdom, with Brexit looming, should have real growth of 1.2%.
In June, I traveled to five cities in Europe over a two-week period and talked to investors and policy makers about economic and political conditions and the outlook for the intermediate term. A number of views have changed over the past year. Concern about a breakup of the European Union has clearly subsided. Countries on the continent believe they are benefiting economically from their membership in the union, and even many in the U.K. realize Britain made a mistake by choosing to leave. Immigration and nationalism were the key issues. Most observers believe the degree of European integration will not progress much beyond the current level, which is based on open borders, free trade and a common currency. There will never be a political union, which was Jean Monnet’s original conception, but the European project, as it is sometimes called, is likely to endure for at least several more years and perhaps indefinitely.
In contrast to a year ago, there is little fear that Greece will drag everyone else down. The country has negotiated a deal with creditors, and its economy appears to have stabilized. Italy, another country with a struggling economy, is expected to grow at 1% this year. Probably the biggest surprise is Spain, which I didn’t visit, but which has recovered nicely from its economic distress several years ago and is expected to grow at 2.3% this year.
Similar to the situation in the United States, European financial markets have benefited from the increase in the balance sheet of the European Central Bank. My view is that central bank liquidity has been a key factor in the performance of the equity and bond markets in developed countries over the past eight years. Now that is changing: the Federal Reserve has already tightened twice with more increases likely, in my opinion, before year-end. The European Central Bank is talking about being less accommodative but has not taken definitive action yet. So far, Japan is still easing.
A shift away from monetary expansion for the world’s major economies is likely to affect future returns, and everywhere I went investors were having difficulty finding attractive opportunities in what they perceive as a continuing low-interest-rate environment. They generally believe the public markets for equities are fully priced; inflation will rise, but not significantly; interest rates will remain low; and earnings will expand at a modest rate. Austerity is no longer considered a favorable policy alternative.
What they fear is geopolitical dislocation that upsets this unexciting but positive outlook. Possible upsetting events would be North Korea developing an intercontinental ballistic missile that could reach California, Russia invading the Baltic States, terrorist acts becoming more frequent in Europe and the United States, or Iran escalating tensions in the Middle East by supporting anti-Sunni groups. Investors are suspicious of private equity and real estate because they believe EBITDA prices for the former are high and cap rates for the latter are low. There is overbuilding as well, and they wonder who will buy these assets when they are ready for sale.
Europeans don’t know what to make of Donald Trump. There was general agreement that his decisions to withdraw from the Paris climate accords as well as his unwillingness to wholeheartedly back the obligations of Article Five of the NATO agreement have diminished America’s leadership status in the world. The biggest problem Europe seems to have with Donald Trump is his unpredictability. They are used to dealing with mercurial people, but they feel that they don’t know where Trump really stands on many issues important to them. As a result, their confidence in the American policy framework has been reduced. As on my trip to Asia last month, I was asked everywhere whether Donald Trump would be impeached and I told them it wouldn’t happen. Several investors made the point that Trump’s “America First” policy had brought the countries of Europe closer together.
Europe has always been self-absorbed and latently nationalistic and it took for granted that the United States would play a leadership role in dealing with major geopolitical confrontations. Now, Europe can no longer count on that. There is also more talk in Europe about China’s growing influence in the world. China’s “One Belt One Road” initiative, which has it reaching out beyond its borders to increase its trade, investment and influence, is being widely discussed by investors. As I wrote in my last essay about Asia, there is a widespread belief that China will become the largest economy in the world sometime in the 2030s. At that point, it will expect to play a major role in world affairs. Exactly what that means for the United States and investors everywhere is hard to determine at this time.
At the beginning of this year I thought the dollar would be strong against the euro and the yen, but that has not been the experience so far. The reason may be that the inability of the administration to get its pro-growth agenda implemented has reduced the likelihood of tax reform, extensive dismantling of regulation and infrastructure spending happening this year. I still believe we will have some of this legislation passed by the end of the year or in early 2018. That will be an imperative for the Republicans. They cannot go into the 2018 Congressional election without something substantive having been accomplished or their loss of seats in the House of Representatives will be significant.
The recent election in Britain resulted in the Conservative Party losing its majority position in Parliament. As a result, Prime Minister Theresa May will have to form a coalition with minority groups to get legislation passed. Most of the U.K. investors I spoke with did not think she would be in office six months from now. She campaigned ineffectively and has demonstrated uneven judgment in the opinion of many investors. Investment professionals fear that because of populism the Labor Party may gain control of Parliament, which they view as disastrous. Right now, most expect London to continue as the financial capital of Europe, but they believe that a number of back office employees will be relocated to Dublin, Frankfurt or Paris. Everyone in Europe complains about intense regulation in the financial service industry.
There is concern about rising inflation in the U.K. as a result of the decline in the value of the pound and the bilateral trade deals that will be negotiated, but the consensus seems to be that there will be a “soft Brexit” that will be implemented over a long period of time with only gradual overall impact. There are even some who believe there will be another referendum that will reverse the Brexit decision. The key issues facing Britain now are immigration and terrorism. The British are complacent about the economy.
Naturally there is interest in when the next recession will take place in the U.S. I pointed out that the goal of the Federal Reserve is to maintain full employment with low inflation. With unemployment below 5% and inflation at less than 2%, the Fed has achieved its goals and isn’t likely to take precipitous action in the form of increasing rates abruptly. The Fed wants to prolong the expansion as long as possible because it doesn’t really have the monetary tools to get us out of a recession if we get into one. Interest rates are already low and a Republican Congress is not likely to provide significant fiscal stimulus. The excesses that usually appear before a recession, like rising unemployment, bloated inventories, increasing inflation, aggressive Fed policy in the form of increased rates leading to an inverted yield curve, are not present. I told the groups I met with that the next recession wouldn’t arise before 2019 or later.
Many European investors anticipate rising interest rates. I told them that inflation was likely to stay low because wage rates and real estate prices were not rising sharply. In addition, the enormous liquidity created over the past eight years was somewhat risk-adverse and looking to the bond market as a place to hide. That’s why we have had negative interest rates in Europe and Japan. I expect interest rates to rise somewhat but to remain low by historical standards. In January, many Europeans expected the price of oil to rise this year and asked me why it had dropped into the $40s. I explained that inventories were very high and had to be worked off, technology had made hydraulic fracking profitable at lower prices for crude, and Iran and Iraq were producing more. These factors, coupled with modest demand increases, partly because of natural gas substitution and renewables, are behind the decline in price.
Investors in Europe are puzzled as to why the unemployment rate in the U.S. is low when so many factory workers have been displaced by globalization and technology and artificial intelligence has reduced employment in the white collar sector. They know that the participation rate has dropped, but that doesn’t provide a complete explanation. They worry that inequality will lead to a rise in populism throughout the democracies of the West and result in political instability going forward. They fear that an aging population will require more support from the limited resources of government and that the various authorities won’t be able to meet their needs. A number of European investors are expanding their exposure to emerging markets. They know they may be early, but with a growing middle class and abundant natural resources, several countries should begin to outperform at some point in the future. With valuations for public securities in the developed markets high, emerging markets look relatively attractive.
I told investors that my favorite emerging market was India and that I thought Japan was underestimated as an equity market opportunity. Most agreed that India was attractive, but I experienced major pushback to the Japan idea. Those opposed said that the only reason the market was doing well was because of massive monetary stimulus. Shinzo Abe’s Third Arrow of governance improvement, regulatory reform and investment has not taken hold. I pointed out that earnings for corporations were strong, (the first quarter was +27%), valuations were lower than in the U.S. and Europe, and Japan was underrepresented in institutional portfolios, but investors were skeptical. If they change their mind and start buying, the results could be dramatic.
At the beginning of the year, I believed modest growth would take place across the world. I thought real growth in the United States would be around 2%, growth in Europe and Japan 1.5%–2.0% and in China 6.5%. I expected Donald Trump to get some part of his pro-growth agenda through Congress and implemented in the real economy. As a result, I thought there was a reasonable prospect for real growth in the United States to be moving toward 3% during the year. As events have developed, the new Administration is spending its time defending itself because of actions which allegedly took place before the election and tweets that took place afterwards. It is off to a slow start in putting its ambitious program to work. But Donald Trump has been lucky throughout his life and the U.S. economy has picked up momentum because of natural forces. By almost any economic measure, the economy is reasonably strong and real growth for the year is likely to come in closer to 2.5% than 2%. First quarter corporate profit increases were twice the 5% originally projected and this trend is expected to continue.
As for the equity market, it seems unstoppable. With earnings of $125, the Standard & Poor’s 500 is selling at 20 times. This is above the historical average, but at current interest rates it is a reasonable multiple in comparison with the relative unattractiveness of bond returns. My beginning of the year target for the index was 2500; we are basically there, but my dividend discount model shows the S&P 500 could trade above 3000 at these interest rates. Naturally, the market could be vulnerable to a 10% correction at any time. It is overbought and investors are overly optimistic. I have stressed the importance of liquidity in driving valuations higher. For most of the last eight years the S&P 500 has moved in tandem with the expansion of the Federal Reserve balance sheet. Since the beginning of 2017, the Fed balance sheet has been flat but the S&P 500 is up 10%. We may experience a summer correction, but the longer-term prospects remain favorable, so hang in there if a downdraft occurs.
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