European equities roundtable: Can the recovery continue?

Chuk Wong, vice-president and portfolio manager at GCIC Ltd. Wong’s mandates include Dynamic European Value, Dynamic Global Value and Dynamic Far East Value.

Peter Moeschter, executive vice-president, Franklin Templeton Investments. A value manager, Moeschter runs both EAFE (Europe, Australasia and Far East) and global portfolios for retail and institutional clients.

Paul Musson, senior vice-president and head of the Ivy team at Mackenzie Investments. The team’s responsibilities include Mackenzie Ivy Foreign Equity, a global fund, and Mackenzie Ivy European Class. Musson seeks to buy high-quality businesses and not overpay for them.

The European equities roundtable was moderated by Morningstar columnist Sonita Horvitch, whose three-part series continues on Wednesday and concludes on Friday.

Q: Let’s discuss the global economic picture as a backdrop to our assessment of the European economy and the European equity market. The latter has been on a tear over the last year or so.

Wong: I see a broadening of the global economic recovery, led by the United States and followed by Europe, which, in the second quarter of 2013, exited from a protracted recession. Japan is showing signs of a turnaround and China has arguably bottomed. If the momentum continues, there is a chance that there will be synchronized growth of the major economies in 2014. The last time we experienced this was in 2006. The projected global growth is expected to be sub-par. This is positive for equities. We are talking about low economic growth, still low interest rates and low inflation.

Q: What is the outlook for the global equity market?

Wong: There are near-term events that might create more volatility in global financial markets. An example is the U.S. Federal Reserve Board’s tapering of its quantitative-easing program. Also, the negotiations in the United States on the federal debt ceiling could cause uncertainty. The upcoming German elections are another question mark. Then there is the civil war in Syria.

Musson: The U.S. job numbers reported on Friday, Aug. 6, were disappointing, raising hopes among some investors that Fed tapering would be delayed and zero interest rates would be sustained. This is somewhat perverse. Normally, when you are investing, you are hoping for a stronger economy. Personal, corporate and sovereign balance sheets are structured for a very low interest-rate environment. If this changes quickly, there will be problems. There is a lot of debt. There needs to be a lot of de-leveraging and restructuring. I agree with Chuk that over the longer term, there will be more subdued global economic growth. For the high-quality companies with strong balance sheets that we invest in, this is a great economic environment. But, it is a question of the stock markets’ valuation of these businesses. The stock markets have been strong both in the United States and in Europe.

Q: Paul, you had some 22% in cash and cash equivalents in Mackenzie Ivy European Class at the end of July.

Musson: It is challenging to find the quality of companies that we invest in trading at reasonable valuations.

Wong: The stock markets in the United States are making new highs. While the European equity market has had a great run, Germany is the only major market in Europe that has hit new highs in recent months. The UK is about 6% or 7% below its all-time high.

Moeschter: Our portfolios are positioned for a global economic recovery, with a focus on the more cyclical stocks. We have a positive outlook. Since this panel met last October, things have stopped getting worse. The euro has survived. There remains strong political and central bank support for the currency.

European stocks have done well in the past year, though corporate earnings are still well below their 2007 level. European equity markets have rallied in anticipation of things getting better. European economies are slowly getting stronger, but there will not be runaway growth. This is not necessary in order to make money on some of these European companies. We are value managers and consider that there are still bargains to be had in Europe, but there are opportunities everywhere.

Musson: I am cautious on Europe. There is a lot of hope that things will continue to move forward.

Moeschter: There is still a lot of skepticism about Europe. For us, skepticism is where you can make money.

Wong: In terms of the sovereign-debt crisis, my view is that the worst is over. There are three key structural challenges facing Europe: the high fiscal deficit, the stability of the banking system and finally, the competitiveness of some of the European economies.

These challenges are showing signs of improvement. The peripheral economies like Greece, Spain, Ireland, Portugal and Italy have come a long way in reducing their fiscal deficits. Most major banks in Europe have been recapitalized. Because of the weakness in some European economies, we have seen major wage cuts there and an improvement in competitiveness.

Moeschter: The financials are our largest sector weight in our EAFE developed-market funds. Most of this sector weight is in Europe, spread between a range of banks and insurers.

On the European economies, I am not sure that the reforms in some countries have gone far enough. There is a need to make it easier for people to find jobs and for those who wish to, to start businesses. The regulatory red tape needs to be reduced. There is also a need to encourage banks to lend again to small- and mid-sized companies. The banks are being extra cautious.

Over the next decade, countries like Spain and Portugal, which have introduced tough measures, will likely see the greatest improvement in their productivity. They have a low-cost labour base and will likely attract significant foreign investments to take advantage of this. It is easy, for example, for a German company to incorporate into its supply chain a manufacturing plant in, say, Portugal or Spain.

Wong: Ireland has come a long way too. As is the case with Spain, Portugal and Greece, the Irish government did bite the bullet and implement harsh measures. There have been major wage cuts in Ireland. This, plus Ireland’s abundant supply of skilled labour, has attracted multinationals back to the country to set up their regional offices there.

Musson: There is an ongoing debate between those who advocate austerity to fix Europe’s problems and those who advocate more spending. Austerity is not about growth. It is about fixing an unsustainable situation, where the country is living beyond its means and its debt is piling up. It has to stop. Austerity is short- to medium-term, painful medicine. You cannot expect growth during this time. There is a lot of positive restructuring going on in Europe. Is it enough? It is difficult to take these measures politically, and the process is slow. You have to change peoples’ mindsets.

Moeschter: Is the restructuring in Europe enough? You probably won’t know that until decades later. Most of the financially troubled countries have taken significant measures to cut spending. In some cases, they have had no choice. Business confidence in Europe is picking up and businesses are investing a little more and that tends to create jobs. Also consumer demand in countries like the UK and Germany is picking up. Ultimately, this incrementally better business investment and consumer spending will drive Europe forward. But it will take years for the unemployment rates in Europe to come down