Is Europe becoming stagnant?

In my August 2012 article Make a Europe splash with Aussie cash, I made the call that investors should look to Europe for investment opportunities.

The Australian dollar was high, European shares were cheap – it was a veritable smorgasbord of opportunity. Fifteen months later the major European indices are certainly stronger. Since August last year, the German Dax is 33% higher, the French CaC is 24% higher, the British FTSE100 is up 15%.

Throw in the 11% depreciation of the $A and that’s a very strong return of between 26% and 44%. More if you look at some of the large cap European stocks, which are up over 50% on an exchange-rate adjusted basis. This compares favourably to the All Ords’ gain of 23%. A year later this call has now gained significant traction (see Cliona O’Dowd’s piece Kerr Neilson dives into Europe. Moreover, we’re seeing plenty of press on the on the issue as well – domestically and abroad, recent data shows that US investors have pumped record amounts into European equities.

The question for those investors who bought back in 2012 and want to stay ahead of the curve – or those considering taking the plunge now – is whether the best has past. To sell into the herd and take the gain, or hold (or get in) in the hope of more. Not such a straightforward question when, at the same time, investors are herding into European equities, high-profile global commentators and some of the major financial institutions are talking of a ‘secular stagnation’. That is many years of weak demand and sluggish growth – a lost decade for Europe even. If that’s true, then the fact is we are talking bubble territory for European stocks already.

The idea of secular stagnation was given prominence by Larry Summers (a professor of economics at Harvard and US policy big wig) recently at a speech to the IMF. Now, while he was talking more about the US recovery, the theory is perhaps more relevant to Europe. That is, if it is true for the US, then it’ even more so for Europe – given its shrinking population.

Should investors be worried about ‘secular stagnation’?

The problem I have with the secular stagnation theory, and Larry Summers’ speech more generally, is that no reason was offered as to why Europe would face permanently weak aggregate demand, and an aversion to investment. That is weaker than normal. Back in the 1930s when the theory was first proposed, it was thought that technological innovation had perhaps peaked, and that this, alongside slowing population growth, would lead to permanently lower growth. Clearly that didn’t happen, and the theory was debunked.

The issue now, as it was then, is causation. What is going to be the cause of this secular stagnation? I mean, to suggest that technological innovation has peaked is laughable, and while population growth is slowing, that by itself isn’t a reason to expect permanently weaker growth. So then what?

The IMF suggests that demand is, and will continue to be, weak as the public and private sectors continue to deleverage. It certainly sounds reasonable as many countries are indeed heavily indebted and as we know, Europe in particular recently faced a ‘debt crisis’.

The evidence here isn’t that strong though. For a start, there actually hasn’t been any meaningful deleveraging. Take a look at Chart 1 below. Its shows Euro zone public debt to GDP rising, not falling. That’s hardly deleveraging, is it? It’s a similar story when you talk about household debt, which is just under 100% of income. Up a per cent or so since 2009, and 3% or 4% since 2008.

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So how is something that hasn’t really even happened yet expected to continue to weigh on growth? It’s not possible. I guess the process of deleveraging could start, but then why would it start now, if it hasn’t over the last few years? More importantly, why would it start when debt servicing ratios are low and the promise is ultra-low rates for many years to come?

It is true to say though, that while Europe most certainly hasn’t deleveraged, that credit growth has been very weak. More often than not, and in addition to deleveraging, the suggestion is that this a symptom of Europe’s fragile banks. Effectively, the argument goes that they can’t lend because they themselves are deleveraging and shrinking their balance sheets. There is more truth here, but again this isn’t quite right. Individual countries, and banks within them, may have some serious trouble. Yet, in terms of systemic threats? Well the risks are overstated.

It’s not that there aren’t problems – there certainly are and you can see this most clearly in the rising proportion of non-performing loans – see table 1 below.

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Yet, and according to the European regulators, and something else you can see in table 1, Europe’s banks are well capitalised and highly liquid. In essence, Europe banks (on the whole) are solvent and have ample liquidity. Indeed, the loans to deposit ratio has fallen across the continent and doesn’t appear overly stretched. The bottom line is that banks could lend if they wanted to – and they do want to.

Why? Because they need it. What the banks need, and this is something emphasised by regulators, is for profitability to rise. Look at the low return on equity (ROEs) in the table above. For that to happen, they need lending activity to lift. Then you’ll see these impaired loan ratios come down. The good news is that recent growth figures suggest that Europe is indeed on the mend. Construction activity is picking up, sharply in some cases, and the region is out of recession.

That deleveraging isn’t actually occurring, and probably won’t, means that there is little standing in the way of this growth. Some countries – Portugal, Spain and Greece have problems. For the rest , there were no problems, or not ones they haven’t lived with for decades – or even had worse. For these economies, growth simply ground to a halt. Construction activity halted, investment itself slumped, and nobody wanted to do anything with the spectre of a European implosion to deal with. The hysteria that gripped the market meant that, for firms, taking on debt to fund construction or investment or what have you – even it was commercially brilliant – simply wasn’t viable. Companies were punished for taking risk – and so the European economy when into stasis; it simply paused. The idea that Europe was crushed under the weight of high debt, austerity and deleveraging is wrong.

Conclusion

So while I think the debate is a good one, investors should not be concerned about the idea of secular stagnation. Certainly not for the US, and not even for Europe. Having said that, the idea is gaining significant traction. Larry Summers is a heavyweight in policy circles and investors should take the policy implications of this theory very seriously – ongoing budget deficits, increased debt levels, ultra-low rates for a very long time, and ongoing money printing.

Under the secular stagnation theory, policy makers need to maintain negative real interest rates and effectively blow asset bubbles deliberately in order to attain full employment. Quite obviously this is sheer insanity, but that’s the state of global macro policy at the moment – and as ridiculous as I feel in saying it, it is good for investors over the medium term.

The bottom line is that I think the European recovery has a long way to run yet, and that European equities are still a long-term buy. Stay in or get in – there is still value certainly here. So, for instance, the Dax is still cheap with a current price earnings median of about 15.3, under the decade average of 17. Moreover, the recovery in European banks is only just getting underway – they may be a very good place to look, as I don’t think concerns here are truly justified.