Structural developments and rebalancing efforts have continued to materialise throughout the European region over recent months, especially within the periphery.
Current account balances have returned to surpluses and now stand at 15-year highs. Meanwhile, unit labour costs continue to trend lower, signalling further improvements to competitiveness in the region.
Countries have behaved much more responsibly than they have been given credit for. Ireland is a good example. Ireland suffered from a sharp loss of competitiveness as negative real interest rates overstimulated the economy.
However, since the global financial crisis, Ireland responded quickly through internal devaluation by instigating wage cuts and pension and labour reforms in order to regain competitiveness. Many other countries within Europe have echoed that same trend, which is bringing competitiveness back to the eurozone.
The recovery has yet to materially impact corporate earnings, but this is fully expected to happen. Indeed, we are encouraged following our recent meetings with companies to discuss earnings.
From an industrial standpoint, from a confidence standpoint, and from a consumer standpoint, everything that is being heard should feed through into companies.
European companies also meaningfully restructured after the crisis, reducing costs and improving their market positions. Therefore, many companies will experience significant operational leverage as the recovery gathers pace.
An area of particular interest over the past year or so has been in certain southern European banking names.
Alongside attractive valuations and the scope for a recovery over the medium term, interest is being driven by the potentially favourable impact of industry consolidation in some markets.
Generally, the degree of concentration in a country’s banking sector has a major influence on banks’ profitability and balance sheet strength. In more concentrated markets, it is evident the large players benefit from economies of scale and cost efficiency, as they are able to spread their fixed-cost bases over a greater number of products and customers. Also, in oligopolistic environments, we observe that management teams are more focused on returns and profitability, rather than continually chasing after market share.
Then there are the changes taking place in Spain. In the ‘boom years’ leading up to the crisis, the Spanish banking industry was littered with a number of small local savings banks – known as ‘cajas’ – with over-expanded capacity that had built large exposures to the real estate market.
As the crisis unfolded, the Spanish banking sector was victim to the dislocation of wholesale credit markets together with the burst of the real estate bubble. The sharp economic downturn that ensued triggered a rapid de-leveraging and risk re-pricing by Spanish banks. Credit growth collapsed, loan-loss provisions soared and capital safety buffers were rapidly eroded.
Faced with the cajas’ limited ability to raise equity and the prospects of increasingly demanding Basel III requirements, the Spanish government was forced to take drastic measures, prompting a stunning consolidation of the banking industry and a rapid reduction in its excessive capacity.
Through liquidations, mergers and takeovers, the number of institutions declined from approximately 50 to 12, while the numbers of branches and employees was cut by 20 per cent and 15 per cent respectively.
Bankia, for example, was formed from a seven-way merger of small local savings banks, and today is the third largest bank in the country by deposits. The most troubled assets from the founding cajas were transferred to the government-backed ‘bad bank’ (SAREB), leaving Bankia essentially with a solid and profitable retail business with the potential to eventually generate double-digit returns as the macroeconomic situation in Spain normalises and the company benefits from a gradual recovery in volumes and net interest margins.
With industry restructuring in motion in Spain, its banking sector is now consisting of bigger and better-capitalised institutions benefiting from structurally higher pricing power and set to operate in a more rational competitive environment. This should translate to improvements to underlying profitability, which should cause valuations to adjust accordingly.
Dean Tenerelli is manager of the T. Rowe Price European Equity fund
