Banks, Financial

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Categorized | Equities

Europe Inc: Light amid the gloom

Posted on November 27, 2014

BRUSSELS, BELGIUM - OCTOBER 24: A woman walks past the European Commission building on October 24, 2014 in Brussels, Belgium. Alongside criticism from outgoing European Commission president Jose Manuel Barroso on the UK's stance on EU immigration and a plan to quit the European Court of Human Rights, the UK has now been told to pay an extra £1.7bn GBP (2.1bn EUR) towards the EU's budget because its economy has performed better than expected. (Photo by Carl Court/Getty Images)©Getty

Making strides: a woman walks past the EU flag in Brussels. The European Commission is set to play a more active role in boosting investment

The mood music from the eurozone has changed once more into a relentlessly minor key. Economists worry that the region is about to slip back into recession. Mario Draghi, president of the European Central Bank, warns of the dire impact of deflation. Academics suggest Europe has lost any competitive advantage over faster-growing rivals. Even Pope Francis is worried, telling MEPs in Strasbourg on Tuesday that the continent was now like “a grandmother, no longer fertile and vibrant”.

But through the macroeconomic gloom peeks a more positive picture. Europe’s multinationals, flush with cash, are starting to flex their healthy balance sheets in acquisitions and overseas expansion. Even the continent’s smaller companies are showing signs of life.

    “From a corporate credit perspective, we believe that macroeconomic concerns are overstated,” says Gareth Williams, economist at Standard & Poor’s.

    This is not to underestimate the strength of the headwinds facing Europe’s companies. Growth in the region is anaemic, at best. This month the pace of recovery slowed to its lowest level in almost a year and a half, with a poll of purchasing managers suggesting that activity would remain weak in the months ahead. Meanwhile inflation is running at 0.4 per cent, well below the ECB’s target of below but close to 2 per cent.

    Even the well-known macroeconomic negatives have a flipside, however. Ignacio Galán, chairman and chief executive of Iberdrola, Spain’s largest power utility, says that although low inflation means most companies have very little pricing power, it has made bosses’ lives easier in other ways. “In certain situations [low inflation] can provoke a more stable situation in terms of wages reducing,” he says. “In the past, high inflation means that we are forced to have difficult negotiations at this level.”

    Deflation is also one of the few ways for peripheral Europe to regain competitiveness within the eurozone. “Within a monetary union a country cannot devalue its nominal exchange rate to regain lost competitiveness,” argues Dirk Schumacher, a Goldman Sachs analyst. “A decline in the price level relative to other countries is therefore the only option left to reduce its real exchange rate.”

    Other macroeconomic developments are more unequivocally positive.

    At the beginning of the year, the loudest complaints from business leaders concerned the price of energy and the euro. In March the European Round Table (ERT) of Industrialists, the influential lobby group of 50 chief executives and chairmen of Europe’s leading multinationals, warned that the region’s high energy costs and strong currency risked derailing its recovery.

    Euro and energy advantage

    Now both trends are going in the right direction. The euro has fallen 4 per cent on a trade-weighted basis since its 2014 high in March, and 11 per cent from its May peak against the US dollar. Meanwhile Brent crude, the international oil benchmark, has fallen about 37 per cent from its June peak and traded around $72 a barrel on Thursday.

    “It is undeniable that a lower oil price and a lower euro is a positive. It has got to be a windfall for the European economy,” says Paul Watters, head of corporate credit research at S&P.

    Given that nearly half of listed European companies’ sales are overseas, UBS estimates that a 10 per cent fall in the trade-weighted euro results in a boost of about 6 per cent to European earnings.

    Falling energy costs and improved foreign exchange earnings are also playing out against a backdrop of easy money, at least for Europe’s multinationals. On this front, issues that had dogged the market as recently as 18 months ago have all but disappeared. For instance, Myriam Durand, Europe, Middle East and Africa managing director for corporate finance at Moody’s, says concerns about the “refinancing wall” of maturing corporate bonds that European companies were going to hit have evaporated.

    “The refinancing issues that we had been really worried about have largely been taken care of and the corporate world is sitting on large cash piles,” she says.

    Smaller companies have also been able to take advantage of easier borrowing conditions. The Moody’s Liquidity Stress Index, which falls when liquidity improves and rises when it weakens in a universe of non-investment grade companies, dropped to an all-time low in August of 10.7 per cent, compared to its peak of 18.8 per cent in December 2012.

    The western European leveraged loan market is back to its pre-crisis peaks – volume stands at $251bn this year, up nearly a quarter from 2013 and the highest year-to-date volume since 2007. Meanwhile, there were twice as many initial public offerings of European companies in 2013 than in 2012, according to Dealogic, and deal volume this year, at €30bn, is three times higher than the whole of 2013.

    Banks in a better place

    The conclusion of the ECB’s asset quality review and stress tests of banks should also result in further relaxation of lenders’ caution.

    “Now that we’re through the comprehensive test, hopefully that will strengthen market confidence in the banking system, and banks will also feel more confident to lend,” says James Watson, director of economic affairs at BusinessEurope, the Brussels-based lobby group. Industrialists agree. “In the past few months a lot of things have been done in Europe that are positive,” says Mr Galán. “The banking union is a very important step.”

    Even the lack of access to bank lending during the financial crisis, it can be argued, has had positive effects, with small and medium-sized enterprises reducing their
    over-reliance on banks and diversifying their funding sources.

    While the improvement in smaller companies’ borrowing conditions should not be overstated, large corporates have benefited from years of rock-bottom interest rates in the public debt markets, and are now sitting on fat cushions of cash. Investment, though, is still stagnating despite being much needed to maintain depleted capital stock as well as develop new projects.

    “I don’t think there is any company CEO who likes to keep cash on the balance sheet if there are good investment opportunities,” says Vittorio Colao, chief executive of Vodafone and a member of the ERT. He blames bureaucracy for muzzling investment rather than the lack of attractive projects.

    Although shareholders still seem unwilling to pressurise chief executives to spend the cash on their balance sheets, mergers and acquisitions have picked up, fuelled by cheap financing as well as plump cash balances. European dealmaking, according to Deloitte, has doubled from $300bn in the first nine months of 2013 to more than $600bn in the same period of 2014. Nearly a third of loan issuance in the primary European loan market this year has been acquisition-related – the largest quarterly total since the financial crisis.

    Even if companies continue to hold on to their cash, there are hopes that the European Commission will play its part in boosting investment. Jean-Claude Juncker, commission president, on Wednesday presented a €300bn investment programme for the next three years to the European Parliament. Although the amount of new public funding will be limited, corporate Europe has welcomed the move, as well as the restructuring of the commission.

    “There is a real need in Europe for a growth agenda, which is what I am expecting from the new European Commission,” says Michel Combes, chief executive of Alcatel-Lucent, the French telecoms equipment maker. “The new architecture of the commission will be extremely powerful . . . and I think [it] clearly understands what is at stake.”

    Benoît Potier, chairman of the ERT as well as chief executive of Air Liquide, says: “The organisation of this commission is along the lines more or less of what we suggested . . . breaking the silos that we had in the past.

    “The glass is still half full at this stage rather than a glass which was half – if not more – empty.”

    Whether growth in Europe picks up, its multinationals have already diversified beyond the region in a trend exacerbated by the financial crisis. Morgan Stanley expects the share of European corporate revenues generated within developed Europe to fall to 46 per cent in 2014 from 71 per cent in 1997, and the heads of Europe’s multinationals insist their performance is no longer so dependent on the region.

    Vodafone, says Mr Colao, is “based in Europe, but not European in terms of the prevalence of customers or markets”, for example.

    From this perspective, the fact that the US has recovered faster than Europe is a growth opportunity. “Long term we still have a very healthy portfolio of [investment] opportunities, some of them in Europe but the rest being in the more dynamic economies – the US, China and the Middle East,” says Mr Potier. Iberdrola’s Mr Galán adds: “Almost two-thirds of our business [is] outside the EU in emerging countries or countries that are growing very fast like the US.”

    Expansion expectations

    And the demand outlook for Europe’s goods is still encouraging. “Looking at a sample of manufacturing purchasing managers’ indices for 19 major economies shows that 14 are still reporting expansion,” says S&P.

    This is not to obscure the many challenges that Europe’s businesses face. These include relentless competition both for export markets and inward investment. Europe’s share of global foreign direct investment, 40 per cent in 2007, had fallen to just 20 per cent by 2012. Accounting for nearly 600 of the world’s top 2,000 listed companies by market capitalisation a decade ago, it now represents fewer than 400.

    Low, or non-existent, growth in domestic markets will pose long-term problems and changes in behaviour forced by the financial crisis – such as hoarding cash – may well prove permanent rather than temporary. But it is easy to miss the good stories amid the pessimism that characterises much of the macroeconomic debate.

    “Europe as a single economic bloc has great strengths as a market and as a place to produce. It is the duty of companies to underline that what Europe needs is scale, lower regulation and more harmonised regulation,” says Mr Colao.

    “I am a fundamental optimist about Europe getting our act together, and the richness of the skills we have in Europe is a good basis to start from.”


    Energy: politicians and business play catch-up

    Analysts suggest the emerging markets and leading eurozone economies benefit more from the fall in the oil price – which dipped under $72 a barrel in trading on Thursday – than the US and Japan.

    According to UBS, a $15 decline in the price of a barrel of oil adds 0.25 percentage points to eurozone growth after one year, with
    energy-dependent Germany
    getting a slightly bigger benefit. Reduced oil prices lower input and energy costs for companies and lift consumers’ spending power, hopefully leading to a rise in demand.

    More than 27 per cent of listed European companies’ earnings could be hurt by falling commodity prices, given that the oil and gas sector makes up 12 per cent of profits and a quarter of capital expenditure in the region. But consumer-tilted sectors, which represent nearly a third of profits, will benefit.

    However, Europe has been caught on the wrong end of radical shifts in energy prices as the shale gas and oil boom in the US has taken off, sharply reducing costs for its companies. Balancing the demands of sustainability, affordability and security of supply is placing policy makers in a dilemma. In Germany, for example, a decision to exit nuclear power and move to renewables has created a supply shortfall and resulted in a rising reliance on dirty coal-fired power stations.

    Meanwhile, the European Round Table of Industrialists, a lobby group, calls for shale gas exploration to be allowed “under appropriate oversight” and for a genuine single market in energy, with a single regulator.

    “Energy is crucial
    for the European industrial renaissance, [and] absolutely required is energy union – [the] same taxation, same levies, cleaning up the tariffs that we pay, which the Americans are not,” says Ignacio Galán, chairman and chief executive of Iberdrola