At last, the Brits have settled the question of their EU membership. So, after a period of market movement, we ALL can invest in Europe, make loads of money, and retire happily ever after, right? Well…not so fast Micky. Because even with the Brexit issue settled, Europe continues to be plagued with serious problems, many of which, are systemic, and many of which, could severely rattle the financial markets, and I don’t mean in a good way. Solutions would give European corporations a big boost to their competitiveness, and for the most part, European policymakers can move to “fix” the problems.

 

Not all Bad News for Investors

Long Term Investing , Brexit, Investment Risk, Value Investor, Value Investor Discussion Forum, Value Investing, Investment Strategies, How to Invest in Stocks, Portfolio Strategy, Stock Market Investing, Economics, Euro, European UnionTo be clear, Europe cannot be viewed as a monolith. Out of the EU28 countries (now EU27 minus the UK), there are several which have recovered, and compete at post-financial crisis levels. Countries such as Denmark, UK, Finland, and Germany. There are also many companies that are generally performing well, thank you very much. Companies such as L’Oreal, HSBC, Bayer, and Siemens. However, as a whole, the EU is struggling. As a value investor, who uses a long-term strategy when investing in the markets, I consider Europe’s problems as serious medium to long term downside investment risks. Combined with other factors, such as high valuations and low returns, it makes the present period an inopportune time to buy European equities, even while stock-picking, and especially if using a passive investing strategy.

 

Read: 10 Rules for Successful Long-Term Stock Investing

 

My Post-Brexit Investing Strategy

In fact, I will be selling into any rallies that may develop over the next few weeks or months. It is a continuation of an operation, began months ago, of trimming back on European equities. The trimming will allow me to accumulate more dry powder for future investment opportunities, as Europe starts to show signs that it is slowly pulling out of its prolonged period of very, very low growth. I am still long Europe, but there may not be another chance to rebalance the risk in my portfolio, at these relatively high valuations, for the next 5-8 months, by then we could be looking a U.S. recession in the eyes.

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Despite the fact that in 2015 European corporates outperformed their U.S. counterparts for the first time in 5 years, weak corporate earnings have been the hallmark in Europe since the end of Fed QE and the self-inflicted wounds on markets resulting from Greece-EU brinkmanship. Analysts assess that European corporate earnings still have more room to grow, and that these earnings should outperform other developed markets by Q4. Nevertheless, it is impossible for me to ignore the many investment risks that converge in Europe over the next couple of months. The risks have so far depressed European markets and they appear to be growing. So, I cannot wait patiently and inactive for a potential growth spurt in Europe as risks factors accumulate and risk levels increase in my portfolio.

 

Investors Also Use Canaries

Up front, I have put a lot of analytical emphasis on the performance of Germany, the UK, and France as these three countries generate over 50% of Europe’s GDP. Moreover, the center of gravity of continental Europe’s political leadership is a Franco-German consensus, which has existed since the conclusion of World War II. Furthermore, Germany and France are the bastions of EU and Eurozone values. If either country wavers in its support of the EU then that could indicate a serious problem. Germany and France are the canaries in the coalmine, so to speak.

 

In no particular order, here are some of the major downside risk factors that I considered when I decided to pull back from European equities.

 

Other EU Membership Votes Would Shake Investor Confidence

As it happens the Brits aren’t the only ones who’ve been thinking of quitting the European Union. There are eurosceptic political parties in many EU countries. More troubling is the strength of these anti-EU parties in the productive northern European countries such as Denmark. The big guy on the block, Germany, has its own homegrown anti-EU movements. More secession votes would further shake investor confidence in the Eurozone.

Germany’s populist and eurosceptic AfD party won 4.7% of the vote in 2013. Now, 2016, the party is stronger.

“The AfD is riding high in the German polls on a wave of public discontent over the migrant crisis, and recorded its highest ever support less than a week after it adopted an anti-Muslim manifesto. It is now in third place on 15 per cent, just five points behind Mrs Merkel’s main coalition partner, the centre-left Social Democrats (SPD), who have slipped to 20 per cent.”

The Telegraph

 

Even in the other EU stronghold, France, former president and potential future presidential contender, Nicolas Sarkozy has voiced concerns over the present state of the union. To his benefit, he may be seeking to strengthen the union but as the saying goes, “to make an omelet, you’ll have to break a few eggs”. However, one of his rivals for the presidency, Bruno Le Maire, has gone further and stated that, should he be elected, he will hold a referendum on the France-EU relationship. These two diverse views of the EU co-exist in the same centre-right party, Les Républicains, of which Sarkozy and Le Maire are members.

 

Furthermore, following the 2015 terrorist attacks in Paris, Marine Le Pen far-right party, Front National, has promised to also hold a French referendum on the EU. She placed 3rd in the last round of French Presidential elections, at 17.9% of the vote, behind Francois Hollande and Nicolas Sarkozy. So chances are high that the next French leader will come into office with a view of making changes to the EU.

 

Trouble on the Horizon

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If the concept of the EU was put into doubt by either Germany or France due to internal politics then that could spell years of economic uncertainty for Europe. Those two countries alone account for over 30% of Europe’s GDP. The next German federal elections must be held before Oct 2017 and next French Presidential election between April-May 2017. So European investors should keep an eye on their pre-election periods, and expect turbulent markets..

 

Beyond France and Germany, some countries are even rethinking joining the union, Switzerland for one, recently withdrew its EU application. All this to say, strategic investors should assume a state of heightened market volatility, and mounting risk resulting from European politics, will be present for the medium term.

 

Reforms Needed to Boost Business Competitiveness are Slow in Coming

Long Term Investing , Brexit, Investment Risk, Value Investor, Value Investor Discussion Forum, Value Investing, Investment Strategies, How to Invest in Stocks, Portfolio Strategy, Stock Market Investing, Economics, Euro, European UnionThe Euro area represents over 70% of Europe’s GDP and the monetary union of 19 countries has several critical, some would say “life threatening” management issues. These problems stem from its structure as well as legacy issues that were exposed during and in the aftermath of the financial crisis.

The refinancing of Greece, for one, is still unresolved, making a possible reappearance of financial market turmoil a distinct possibility.

”Any unexpected relapse into crisis in Greece could weigh more heavily on investment decisions and thus on economic growth.”

European Commission, European Economic Forecast for Winter 2016

 

Additionally, structural and fiscal reform is crucial to support monetary policy in an effort to pull the economy out of the doldrums and improve competitiveness.

“For this recovery to be consolidated, our efforts should now concentrate on strong policy action to improve the business environment, favor investment and raise productivity,” ”

Mario Draghi, ECB President
Address to European Policymakers, June 2016

 

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The EU political leadership have heard President Draghi’s increasingly urgent, increasingly frequent call to action. Some major players have tried to implement market-oriented policies, players such as France’s left-wing President Hollande, but it has not been easy and the political price has been high. Hollande has faced wave after wave of work stoppages and strikes opposing a pension and labor reform bill. A formidable rebellion from his own socialist backbenchers has also firmed up. In a break with tradition, his party, Parti Socialiste, will force him to face contenders, in a party primary, to be held in January 2017. It could spell the end of his presidency.

 

Without a doubt, many countries within the EU need reform. The reforms should take the form of reducing regulatory bottlenecks within the region and improving conditions for businesses to function and companies to compete aggressively at the international level. The lack of these reforms formed the basis of the Brexit vote. Without reforms there could be other EU membership referendums and more market turbulence.

 

An Out of Balance Banking System is Weighing on Financial Stocks

Along with new regulatory requirements, the ECB zero interest rate policy, designed to boost the economy by boosting aggregate spending, is posing a challenge to the European banking system and that challenge is reflected in banks’ lower profitability.

“…policymakers have also expressed concern about the impact of negative rates on banks’ profitability. Lenders have been reluctant to pass on the costs of negative rates to customers and have taken almost all of the hit”.

Financial Times

 

Further, the follow-on consequences of ECB stimulus, negative interest rate, and asset purchasing policies and their unwinding are completely unknown.

 

A strong banking system is essential for economic growth and right now the ability of European banks to lend, their dividends to shareholders and profitability is suffering.

 

Fed Moves Could Trigger Spill-Over into European Market

Fed tightening, whenever it happens, may have a contagion effect on Europe and stall the region’s economic growth efforts. The transmission mechanism for the spill over effect will come from the emerging markets.

“…the continuation of monetary policy normalisation in the US could have a more negative impact on vulnerable emerging market economies than envisaged in the central scenario and also affect the stability of financial markets. The materialisation of any of these downside risks could negatively spillover to Europe via various transmission channels (including trade, financial markets and confidence).”

European Commission, European Economic Forecast for Winter 2016

 

At this point it is a question of “when”, and not “if” a rate hike occurs. The intervening period before the hike, appears to be where market volatility is the most unpredictable, and that creates risks that may affect EM financial stability.

“The main risk to emerging economies has less to do with the economic impact of the rate hike and more with the potential effects [of a rate increase] on financial market sentiment, flows and debt refinancing conditions,”

Mohamed El-Erian, Chief economic adviser, Allianz and the former CEO of Pimco.

 

Nascent growth in Europe can easily be snuffed out by aftershocks from a financial earthquake originating in EM.

 

Read: Monetary Policies are Serious Downside Investing Risks

 

Restrictions to Movements Across Internal EU Borders Add Costs to Companies

Long Term Investing , Brexit, Investment Risk, Value Investor, Value Investor Discussion Forum, Value Investing, Investment Strategies, How to Invest in Stocks, Portfolio Strategy, Stock Market Investing, Economics, Euro, European UnionThe migrant crisis is putting a strain on country-to-country relationships within the European Union and accordingly the Eurozone.

“The public perception of the increased number of refugees could impact negatively on economic confidence and thereby lower the growth momentum of private consumption. A long-term reintroduction f internal border controls and measures that endanger the achievements of the internal market could potentially have a disruptive impact on economic growth.”

European Commission, European Economic Forecast for Winter 2016

 

Essentially the EU Schengen zone of visa and passport-free travel is under threat. The threat is concrete, potential future French President Sarkozy stated that the current Schengen Treaty should be recognized as dead. Companies needing to move their goods and services across borders now accomplish that seamlessly. Additional restrictions on movement will impose new costs that will add expenses and attack companies bottom lines.

 

A U.S. Recession Would Hit Investors…Hard.

The U.S. is Europe’s largest trading partner. Europe exported approximately $350 billion to the States in 2014 but there is an increasing probability that the U.S. may enter a recession in 2017 and that will have global implications.

“No matter who is elected to the White House in November, the next president will probably face a recession.
The 83-month-old expansion is already the fourth-longest in more than 150 years and starting to show some signs of aging as corporate profits peak and wage pressures build. It also remains vulnerable to a shock because growth has been so feeble, averaging just about 2 percent since the last downturn ended in June 2009.

“If the next president is not going to have a recession, it will be a U.S. record,” said Gad Levanon, chief economist for North America at the Conference Board in New York.”

Bloomberg

 

Any U.S. recession will have a dramatic and negative impact on European corporations.

 

Chinese Downturn with no Clear End in Sight

China is the EU’s second largest trading partner after the U.S. Export-dependent Europe is feeling China’s economic slowdown and emerging markets economic woes while the strong greenback and weak Euro has a somewhat moderating effect. Both imports from and exports to China has dropped. Less trade is occurring between the partners. As China starts looking promising again, Europe’s economy will respond positively.

 

The Cold War Between Russia and the EU: Mutually Assured Destruction

Russia is now the Euro Zone’s 4th largest trading partner, indicative of a drop in trade. In the past, Russia had been Europe’s 3rd largest partner. The change came in 2014, the European Council imposed a trade embargo in protest of Russian aggression in the Ukraine and the annexation of Crimea. The embargo has had a predictably chilling effect on trade between the partners. At this time there are several EU countries, among which is Italy, that are pushing for sanctions to be lifted, as well there have been recent moves by Russian President Putin to normalize trade.

“As the European Union squabbled over refugees, Greek bailouts and austerity in past years, it showed striking unity in another area: its resolve to punish Russia for the annexation of Crimea and support of separatists in eastern Ukraine.

That consensus was possible because German Chancellor Angela Merkel was able to keep Russia-friendly members of her own government on-side and convince skeptical EU states like Slovakia, Hungary and Italy to back extensions of the bloc’s economic and financial sanctions against Moscow.

Another six month extension seems likely….but that cannot hide the fact that the mood in Berlin is shifting. And with that shift, the first real cracks are emerging in the European consensus on how to deal with Russian President Vladimir Putin.”

Reuters

 

When sanctions are lifted there will be a boost to Europe’s GDP, but until then, as with all trade sanctions, corporate profitability suffers.

 

Oil Price Effects on Consumer Spending is Uncertain

Europe is still challenged by low commodity prices, specifically oil. It is unclear what a sharp rebound in crude prices would do to the European economy especially over the upcoming Q4, energy hungry winter.

“Risks of fading tailwind support for the recovery have been somewhat reduced by recent developments in oil prices and the probability of further policy support, but downside risks remain in place. A faster-than-assumed rebound of energy prices would hurt spending plans of households and companies in the euro area and weigh on economic activity.“

European Commission, European Economic Forecast

 

Many people get paid big bucks to say where they think oil prices are heading. I certainly don’t have a crystal ball and won’t even try to guess where the short term price of crude is going. That being said, the acknowledgment within the EU Economic Forecast of significant risks, to me as in investor, is troubling and indicative of an extremely fragile economy.

 

An Unconventional U.S. Election Cycle Poses An Uncertain Investing Environment

Long Term Investing , Brexit, Investment Risk, Value Investor, Value Investor Discussion Forum, Value Investing, Investment Strategies, How to Invest in Stocks, Portfolio Strategy, Stock Market Investing, Economics, Euro, European UnionInvestors hate uncertainty, and the upcoming U.S. election is providing plenty. While it is not clear if either of the Presidential candidates are investor friendly, Trump seems less so as economic and social policies seem to be in a state of continuous flux. This alone may cause angst among investors and result in volatility as November nears. Opinion is all over the map with Politico quoting from a Moody’s report.

“Donald Trump’s presidency would “significantly” weaken the country, driving the U.S. into a “lengthy recession” with nearly 3.5 million job losses and a 7 percent unemployment rate…Broadly, Mr. Trump’s economic proposals will result in a more isolated U.S. economy. Cross-border trade and immigration will be significantly diminished, and with less trade and immigration, foreign direct investment will also be reduced”

Politico

 

We’re in new territory here, but all seems to indicate a strong probability of unstable markets in the lead-up to, and maybe following the November vote.

 

Final Thoughts

The amount of risk that I, as an investor, am being asked to take for a low yielding potential payoff is too high. I am still long Europe, but I have been rebalancing to maintain a stable level of risk.

 

Essentially, investment risks are increasing in Europe. Governments need to step up their game and mitigate the many factors that negatively affect trade. A necessary result of implementing solutions to Europe’s problems will be further integration on the political and/or economic levels. A solution which European governments have to do a better job of selling to their populations if the EU is to be an on-going concern. Of course, if by some miracle, the European economy improves without any of these factors being substantially addressed or resolved, then many of the underlying negative factors, outlined above, will diminish.

 

Politics will in all probability, be the main source of European market volatility and risk. I believe that the political risks will slowly dissipate in the Eurozone’s favor as ultimately, there is a strong political will among the largest economies for the idea of a European “union” which goes beyond economics. While there is a belief that the EU is looking pretty solid in the medium term, for me to further invest in Europe many of the downside risks need to show a glide path to a favorable outcome.

 

It pays to have a long game, being a value investor with a robust long-term strategy.

 

Read: How I Learned to Stop Worrying and Love the Markets

 

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