With economic recovery in Europe “lackluster at best,” investors are left wondering how could there possibly be opportunity for stocks. Dale Winner, co-portfolio manager on the EverKey Global Equity team at Wells Capital Management, explains in this excerpt of On the Trading DeskSM from Tuesday, August 26, 2014.
Briefly, what is the current state of the European economic recovery?
Briefly, it’s lackluster at best. But we now have seen four consecutive quarters of GDP [gross domestic product] growth, although this has been lackluster. For example, first-quarter GDP grew only 0.2%. Also, unemployment in the eurozone is high at 11.5%, and inflation was only 0.4% in July. We are constructive, though, because there’s huge pent-up demand in Europe on a normalized basis.
In a recent CNBC interview, Wells Capital Management’s economist Jim Paulsen indicated that Europe might be a great place for an investor to diversify if the Federal Reserve begins to tighten here in the U.S. With Europe’s recovery being what it is, what’s your reaction to that?
We totally agree with Jim. The U.S. markets are trading close to all-time highs. They are rich in terms of valuation versus their long-term averages. Essentially, they’ve benefited from very aggressive quantitative easing [QE]. On the flip side, they essentially haven’t even started traditional QE in Europe yet. This divergence in the economic prospects and QE between U.S. and Europe is being reflected in dollar strength and euro weakness. This weakening euro will likely be the first catalyst for reflation in Europe, and that should be followed by improved bank lending.
Dale, you talk about financials. In recent months, we’ve seen the European banks come under increased scrutiny from a regulatory standpoint. Do you view those valuations as being attractive at this time, given the central bank policies and balance sheets?
It’s very stock specific for us. We are stock pickers, not macro forecasters. So, we focused on financials that look cheap on their normalized earnings power but in the meantime have a very strong capital basis. We do agree that there’s a lot of regulatory pressure on banks. We feel it’s mostly on the investment banking and wholesale banking side, and so we’ve also tried to narrow down our focus to domestic franchises.
We’ve recently heard from the ECB [European Central Bank] president in Jackson Hole, Wyoming. He expressed his concerns about continued high levels of unemployment and low inflation in the eurozone. What type of impact do you think this may have in your decision-making process?
We feel that Mario Draghi’s comments at Jackson Hole are an extension of his comments from the very important June ECB meeting. We have to wait specifically for a bank stress test that will be happening in September of this year before he can implement his so-called funding for lending scheme, which is offering very cheap, almost free, capital to European banks as long as they lend it out as traditional corporate loans. Once the stress test is behind us, then the ECB will likely be very proactive in stimulating bank lending to stimulate the economy—the other being addressing the euro—which means that European equities will be a net beneficiary of a weaker euro.
Do you have thoughts around what’s going on in, say, the euro versus the non-euro area, developing Europe versus emerging Europe?
Yes, we do. Geographically, we have weightings across different countries in the eurozone and outside the eurozone. So, we do feel that there is the potential for greater economic normalization in the eurozone countries because of their double-dip recession compared to, for example, the U.K., which is actually already normalizing. We have had a good weighting in U.K. companies, and over the next 6 to 12 months we’ll probably be taking some profits as those companies reach our long-term price targets in the U.K. and start to switch to some of these undervalued eurozone cyclicals and perhaps financials, which are much cheaper on normalized earnings. So the real bargains are more in the eurozone countries and within cyclicals based in Europe rather than the U.K.
Do you have any parting thoughts for investors?
Yes. We are definitely sticking to our discipline of investing in companies that are undervalued on their normalized earnings, three to five years out. In Europe, we’ve had a two-year risk reduction phase, and now we are just beginning to enter the economic and earnings normalization phase. And so that’s where we believe the better prospects are in terms of our holdings.
That is all the time we have. Dale, thanks for joining us here On the Trading Desk.
Thanks, appreciate it.