PIIGS can fly

The biggest push-back to our constructive view on the European domestic recovery trade and in particular to our bullish positioning in southern European stock markets is that these are marginal assets, where the success of the investment is too binary and too dependent on investor risk appetite and the overall path of the global economy. Strange then that whilst year to date returns from risky assets have been on the whole disappointing (with most stock markets worldwide having delivered significant negative returns), that all of the stock markets in peripheral Europe should have so far delivered world beating positive returns: Portugal (+5%), Ireland (+6%), Italy (+3%), Greece (+8%) and Spain (+1%)¹. We think that this is indicative of sources of risk in the global economy shifting, as well as opportunities for return. Contrary to perceived wisdom, PIIGS can fly. 

We think that turbulence in emerging economies has further to run, particularly if the US economic recovery proves robust and the Fed can withdraw from QE sooner rather than later and as a result continue to hoover up hot dollar capital flows from shallow EM capital markets. We find a number of compelling short opportunities amongst stocks geared toward emerging market economies where exceptional growth has been over-extrapolated and where market profit expectations remain unrealistic, particularly in view of on-going macro turbulence. Although the market narrative struggles to comprehend a global economy in which developed world economic growth is not a poorer derivative of Chinese and emerging market growth, this used to be a less difficult concept to grasp, particularly when I first began my investment career in the 1990s.

By contrast European macro data continues to be very robust. The Eurozone Manufacturing Purchasing Managers Index hit a 32-month high in January. It is, however, the ongoing improvement in the peripheral economies which is most noteworthy. In Greece, the PMI rose above 50 for the first time since 2009, indicating that the majority of respondents are now experiencing an improvement in business conditions (Grecovery). As observed by Markit, who publish the PMI data, “perhaps the most important development in the (January) report is the further revival of manufacturing in the region’s periphery. Both Italy and Spain are seeing robust growth of output and order books, and the Greek PMI’s rise above 50 for the first time since August 2009 is an important signal of how even the most troubled member states are returning to growth”². In the current embarrassingly irrelevant debate about the lack of inflation in the Eurozone economy, the real economic story – and the investment opportunity - is being lost.

Following their painful multi-year internal devaluations, peripheral European economies are now much more competitive and therefore less risky than is commonly appreciated and will be the beneficiaries of inflows of capital from investors exiting emerging markets. As the macro environment becomes less hostile in southern Europe, we think that companies which have aggressively restructured during the downturn now offer the most compelling opportunities given the scope for corporate profit recovery. As we can see from the table below, corporate profitability in peripheral Europe, as measured by return on equity (ROE %) is still massively depressed, with 2013 ROE between 17% and 38% of the 2007 peak. This gives a good indication of the potential for bounce-back in corporate profits. We believe that share prices will follow corporate earnings revisions and that - assuming peripheral economies continue to recover - we are at the beginning of a multi-year period of world beating returns from the equity markets of peripheral Europe. 

Chart 1: European Corporate ROE by Country

³Argonaut, UBS, 1^st January 2014

We therefore think that the prospect for investing in southern Europe today is akin to investing in Emerging Markets after the 1998 crisis in that the subsequent bull market in Emerging Market equities had its genesis in an economic crisis which necessitated painful economic and corporate restructuring. Just as European equities – or at least domestically exposed European equities – became a pariah asset class as a result of the Eurozone sovereign crisis, the same was true for Emerging Market equities as a result of economic crisis at the end of the 1990s. So whilst today we are concerned about the prospect of on-going turbulence from developing market economies, we also believe that PIIGS can fly.

Barry Norris
Argonaut Capital
February 2014