Politics remains in the forefront of investor concerns, mainly when it relates to Europe. It was Italy & Spain before, then came Brexit and now it was France till early this month. Politics is likely to remain a concern for some time, with UK elections, German elections, Brexit negotiations, etc. History has shown us that political events have a very short term impact on financial markets and many a times these offer opportunities to those who are focused on economic fundamentals.
The structural changes implemented by the Eurozone countries after the GFC (Global Financial Crisis) are starting to show its impact on economic numbers, but given the persistent political headlines, markets are yet to fully discount these fundamentals. Discussing the structural changes will take pages, so we will limit ourselves to look at the fundamentals in Europe and what can drive these further.
There has always been a strong correlation between PMI (Purchasing Managers Index) and GDP growth. The following chart shows the Eurozone monthly PMI numbers plotted along with the Quarter on Quarter (QoQ) Eurozone GDP growth for the last 5 years.
[Source : Bloomberg]
The PMI below 50 indicates that the economy is contracting while above 50 the economy is expanding. Not surprisingly, the Eurozone GDP growth was negative in 2012 (-0.9%) and 2013 (-0.3%), while the PMI remained below 50. Since the second half of 2013, the PMI has moved above 50 and the GDP growth turned positive. Since then, there has been a sustained rise in both the PMI and GDP. In 2015 and 2016, the PMI remained above 52 and 53, which translated into a GDP growth of 2% and 1.8%. In 2017, the PMI remains above 55, which according to many economists should translate to above 3% growth. Putting this into perspective, these numbers are close to the numbers seen during the periods of strong growth prior to the GFC.
In its simplest form, Nominal GDP is measured through the combination of the Quantity of Money in the economy and the Velocity of Money. It can be argued that the ECB with its QE has increased the quantity of money which has driven the growth in GDP. However, money supply can support GDP growth to an extent beyond which underlying economic activity or the speed at which money moves within the economy makes the growth sustainable. The recent jump in PMI to above 56, suggests that the underlying economic activity in Eurozone has improved increasing the velocity of money in the economy. There are a few reasons which lead us to believe that underlying economic activity has improved and growth in the Eurozone is sustainable.
The wage adjustments countries within the Eurozone have made since the GFC has brought costs down for European goods and services. Also, since May 2012, the Euro is weaker by nearly 12% and from the second half of 2013 by nearly 20%. This has made Eurozone relatively more competitive driving Eurozone exports to non-Eurozone countries to grow by over 11.5% since 2013. Apart from this overseas demand, domestic demand is also improving within the Eurozone.
The following chart shows the changes in unemployment, wage growth and consumption in the Eurozone.
[Source : Bloomberg]
In 2012 and 2013 unemployment in Europe was increasing, while wages were decreasing. Because of this household consumption decreased, which in turn led to the lower domestic demand, which coupled with relatively lower global demand had a negative impact on GDP growth. Since 2014, unemployment in the Eurozone has fallen from above 12% to 9.5%. Wage growth in the Eurozone has also stabilised at inflation levels and in recent months showing signs of increasing at a faster pace.
Even in the southern Europe countries like Spain, Italy, Portugal and Greece, unemployment level has been falling, though they are still at relatively high levels. With the workforce in these countries having re-trained and also construction activity improving, particularly in Spain, unemployment in these countries could potentially fall further over the coming years.
The combination of lower unemployment and improved wage levels has translated in to higher spending by consumers. The consumer demand has improved significantly since the end of 2015 and continues to remain at elevated levels. As has been seen in the past, secular growth trends driven by fundamentals, lasts for years before changing course. Increased consumer demand is also driving corporate spending. Eurozone companies have increased investment spending in recent months and have given guidance for higher spending in coming months. Barring any unforeseen circumstances, this spending cycle could continue for a few years sustaining growth.
To look at Europe as a whole, apart from the Eurozone, investors need to also look at the UK. The fundamentals in UK are similar to the Eurozone. Apart from 2008-09, the economy has managed to keep growing. Unemployment and household spending has reached pre-GFC levels. However wage growth in UK still has room to improve.
Therefore, even with all the headline uncertainties, fundamentally Europe as a whole is in a good place. Based on the improving underlying fundamentals, financial assets in Europe remain relatively undervalued. Financial markets eventually catch up with fundamentals. Investors who look through the headlines and continue to remain overweight Europe, until economic fundamentals suggest otherwise, are most likely to benefit over the next few years.
By Kaustubh Misra, CIO, Samsung Asset Management London
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