By Chris Konstantinos, RiverFront Investment Group Director of International Portfolio Management
I recently returned from a two-week visit in the UK, meeting with strategists, economists and the management teams of over twenty public European consumer companies in banking, automotive, food, retail, media, travel, real estate and construction. My purpose was to divine what sort of changes in behavior the British referendum vote has wrought, as well as to get a ground-level view of how consumers across Europe are faring in this tumultuous year. Given our portfolios’ preference for consumer stocks within Europe, we view the findings as an incrementally positive indicator for our current positioning.
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1. EUROZONE CONSUMER: ENCOURAGINGLY RESILIENT (MOSTLY)
The biggest takeaway from my trip was the resilience of the European consumer, with particular strength noted in the UK and Spain, and stability in Germany and Italy. With all four regions reeling over political and banking concerns, we find our positive channel checks encouraging (see Appendix on page 3 for more specific color from our meetings). We think this resilience is related to improving employment, low oil prices, and cheap available credit. France was clearly where commentary was most pessimistic, likely related to terror events and a general malaise in the economy. Our findings are corroborated by strong post-vote retail sales volume growth in the Eurozone and September readings of retail confidence surveys taken by The European Commission (see chart below).
2. THE UK CONSUMER: KEEPING CALM AND CARRYING ON
Given the fallout over Britain’s unexpected vote to exit the EU, the strength of the UK consumer this summer is downright surprising to many. Consumers appear to be “keeping calm and carrying on.”
While sentiment has been damaged by the referendum vote, actual British consumer demand for goods appeared to be robust, according to our channel checks. Why? More than one executive I spoke with reminded us that outside of London, the rest of Britain essentially voted for Brexit, suggesting many consumers are not fazed by the vote’s outcome. Prime Minister Theresa May’s quick appointment was also seen as a positive, as she is generally viewed as pragmatic and level-headed (in contrast to some political leaders in the “Leave” camp). Other potential factors include favorable summer weather in Britain leading to greater foot traffic, continued low UK unemployment levels, and increasingly accommodative policy by the Bank of England.
Another factor to consider is the effect that a weak pound has had on inbound tourism. The New West End Company, representing Oxford, Bond and Regent Street retailers in London, reported spending from the US and Chinese tourists increased 74% and 65% month-over-month, respectively, in August. Average Chinese spending was an eye-opening £1453 per person, with luxury sales up 19% year-over-year. However, weak currency can also impact margins, and we expect this current environment will prove to be difficult for many smaller UK retailers who cater domestically and are sourcing product in USD.
3. UK REAL ESTATE: MIND THE GAP (DOWN)
In contrast to retail spending, however, UK real estate appears to us to be a pressing concern. London housing, cooling even before the vote due to stamp tax hikes, now appears to be in a bear market in certain segments, though lack of supply probably means less extreme downside than mega-bears believe. UK commercial real estate trends so far appear more resilient than residential, as rents haven’t moved much yet (See comments in Appendix on page 3). However, commercial real estate is likely to come under greater scrutiny in 2017 when actual Brexit negotiations start to profoundly color business sentiment.
To that end, data suggests that business sentiment in the UK has recovered after a sharp spike down right after the vote. But if I hoped to return stateside with uniformity around how businesses were thinking about Brexit risk, I left empty-handed. To paraphrase the European head of one of the world’s largest corporate banks, “no one actually knows what it means…but when [Article 50] gets signed, it will be a different story”. Analyzing PM May’s unequivocal statements on immigration policy over the weekend and movements in sterling, it would appear the market believes the likelihood of a hard Brexit (i.e., Britain leaving the customs union and single market) is increasing. But, we would caution drawing too many conclusions yet, with so many chapters yet unwritten. It’s probable that the definitive answer to what Brexit will actually look like will take years to reveal.
4. EUROPEAN BANKING RISKS: POOR FUNDAMENTALS… BUT UNLIKELY TO BE SYSTEMIC, IN OUR VIEW
As bears on European bank equities (see Weekly Views from 8/30/16, 7/11/16 and 6/13/16 for more on our view of European banks), perhaps we are just indulging in confirmation bias, but I found very few encouraging data points on financials during my trip. A bitter cocktail of negative interest rates, slow economic growth and the continual need for increased capital buffers have made bank valuations a moving target. One banking analyst I spoke to said that current fundamentals of the European banks reminded him of the Japanese “zombie” banks of the 1990’s, and he believes that earnings revisions should stay solidly negative for the foreseeable future.
We find it ironic that Germany, an outspoken critic of bank bailouts for countries like Italy, may be forced to witness one of their own making. Despite Deutsche Bank’s well-publicized failings in capital adequacy, we don’t believe that German banks will cause a systemic meltdown of the global financial system, a la Lehman Brothers in 2008. Why?
- European Central Bank (ECB) is now the banking regulator/lender of last resort, which was not the case during the global financial crisis. In our view, Deutsche Bank is likely too big to fail, so we believe the ECB would likely backstop.
- We believe, based on recent reports, that the US DOJ settlement for Deutsche Bank’s residential mortgage-backed securities lawsuit is likely to be significantly less than the $14 billion initial headline number (AFP report on Friday suggests a number more in the range of $5.4 billion, though this is not substantiated yet).
- Counterparty risk management processes have learned from the Lehman meltdown – collateral on derivatives are now standard operating procedure, so contagion risk from a global investment bank is likely lower, in our view.
- We predict that the German government is more likely to go for a “bail-in” (shielding depositors at the expense of shareholders and some bondholders) than a bail-out. The key here is preventing a run on consumer deposits.
APPENDIX: SIGNIFICANT MACRO COMMENTARY FROM MY MEETINGS
Important Disclosure Information
Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability.
High-yield securities (including junk bonds) are subject to greater risk of loss of principal and interest, including default risk, than higher-rated securities. In a rising interest rate environment, the value of fixed-income securities generally declines.
Mortgage-backed securities are subject to prepayment and extension risk; as such, they react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain mortgage backed securities.
Using a currency hedge or a currency hedged product does not insulate the portfolio against losses.
There are special risks associated with an investment in real estate and Real Estate Investment Trusts (REITs), including credit risk, interest rate fluctuations and the impact of varied economic conditions.
Technical analysis is based on the study of historical price movements and past trend patterns. There are no assurances that movements or trends can or will be duplicated in the future.
RiverFront Investment Group, LLC, is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). RiverFront also serves as sub-advisor to a series of mutual funds and ETFs. Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations. Copyright ©2016 RiverFront Investment Group. All rights reserved.
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