Worries about the fiscal situation had driven valuations to historic lows, resulting in significant opportunities for bottom-up investors to take advantage of mispricing arising from a volatile and macro-driven market. Despite the recent rally, valuations still remain attractive. However, we believe that the market continues to miss the bigger opportunity, beyond the near-term optical valuation gap, for the structural reforms taking place across Europe, which can secure the region’s competitiveness in the years to come.
One of the widely held beliefs used to justify pessimism about Europe relates to the competitive dynamics within the eurozone.
The bear thesis argues that since the formation of the euro, the periphery countries have seen a steady erosion of their competitiveness against Germany. As Exhibit 1 shows, Germany is now far more competitive than many of these countries from a labour cost perspective – so why would businesses operate from anywhere else within the EU?
Source: ECB
It is widely argued that the only possible solutions to this are for Germany to allow its costs to inflate dramatically or for the peripheral countries to suffer savage deflation.
Germany will not allow the former and the latter would obliterate the peripheral economies, worsening their governments' funding issues.
We believe this simplistic view is narrowly focused on the wage costs involved in production, when in fact the efficiency of production appears to be more relevant here.
We can see from Exhibit 2 that average annual salaries in Spain, Portugal and Greece are in fact much lower than those in the core countries. This shows that the problem with unit labour costs (ULCs) is related to productivity and not to the level of wages.
Source: ECB
Exhibit 3 shows productivity for the same EU countries, and we can clearly see the lack of productivity for the peripheral economies, but also how little they have managed to improve productivity over the past decade.
The notable exceptions are Ireland and more recently Spain, both of which provide some evidence that productivity can improve rapidly.
Source: ECB
Changing productivity is often regarded as being a long-term project. However, we think there are many ways in which productivity can be improved and some of these can be done quite quickly.
While longer-term projects will focus on improved education, investment in R&D and other areas, in the short-term, changes in working practices can have a dramatic effect, as can the nature of businesses active in an economy and the level of capital investment in those businesses.
Productivity is also calculated across the whole economy; however, there are businesses where the market is entirely domestic.
For instance, the productivity of a shop worker has little impact on the competitiveness of their economy against their global peers.
We feel that the improvements in productivity will be closely linked to the progress of austerity measures that are being put in place across Europe.
We think that labour market reforms and other measures that will work to increase productivity will have a far more important impact on these economies than the immediate changes to taxes and spending.
If labour markets can be made more flexible and if welfare systems and public sector employment can be changed to incentivise productive private sector employment, then the peripheral countries could see sizeable improvements in productivity (and hence ULCs).
Instead of regarding productivity as a structural weakness, it could come to be viewed as a strong structural growth driver.
Often, in fact, productivity improvements are imported into a country by a manufacturer, so what becomes extremely important is that countries can attract these manufacturers.
A country’s attractiveness to industry increases through measures such as flexible working practices, government incentives and lower social security costs.
We can see this working in practice in Europe already, with Ford closing three of its European facilities (one in the UK and two in Belgium) and moving production to more attractive plants, including Spain.
Similarly, Renault is increasing production of new vehicles and parts in Spain, securing all existing jobs and creating new roles.
Although the risks associated with Europe remain elevated, the total collapse of the euro has not happened as prophesised.
Progress is being made, perhaps too slowly for some, but the ECB’s support for the euro has been firmly established.
The stresses around the euro area and the market forces of bond yields widening for the periphery have been used to force structural change around Europe.
These changes have the potential to transform Europe’s competitive landscape.
As this process improves the financial productivity of Europe, we believe further significant opportunities to buy attractive companies on compelling valuations will open up.
Aaron Barnfather manages the Lazard European Alpha fund. The views expressed here are his own.