Spain and Italy look to have withstood austerity policies, with fresh growth slowly feeding through to corporate profits, according to Old Mutual’s Kevin Lilley.
The manager of the group’s European Equity fund noted Spain recorded its fastest pick-up in economic activity in six quarters for the period ending March 2014.
The country is forecast to grow 0.9 per cent in real terms for this year, according to the International Monetary Fund, while Italian GDP is set to rise 0.6 per cent across the same period.
“Both Spain’s prime minister Mariano Rajoy and his reformist (but as yet unelected) Italian counterpart Matteo Renzi have been key in introducing change to their inflexible labour markets and restoring positive sentiment,” added Mr Lilley (pictured).
“Italian consumer confidence for April jumped to its highest level since January 2010, while Spain continues to reap the benefits of its employment reforms.
“According to annual data, Spanish unit labour costs fell by 7.2 per cent over the period from 2009 to 2013 and the decline is even more noticeable in Greece at 13.3 per cent over the same period.
“Contrast this with Germany where unit labour costs have risen by 5.1 per cent over the past five years.”
Against this backdrop, Peugeot, Renault and Volkswagen have increased their automotive manufacturing capacity in Spain, making cars one of the country’s biggest exports.
According to Mr Lilley, this new confidence in peripheral markets is clear from Spanish and Italian bond yields, with 10-year paper in the latter cheaper than ever and five-year debt in Spain costing less than US equivalents for the first time since 2007.
“Critics would argue yields are more a reflection of different stages of monetary policy: while the US tapers its quantitative easing programme, European Central Bank president Mario Draghi is hinting at credit easing,” added Mr Lilley.
“Nevertheless, low bond yields across the eurozone as a whole mean the economic virtuous circle remains intact. Falling yields lead to lower government funding costs, which in turn allow banks to lend to businesses at more attractive rates, thus boosting economic growth.”
On the equity front, analysts have upgraded earnings for Catalan-based Banco de Sabadell as the percentage of the bank’s bad loans tail off. Mr Lilley said he believed this pattern of improving asset quality will be repeated across other domestic-orientated banks.
“Despite the forward multiple of peripheral countries – 16.4 times versus 15.9 in the US – it should be remembered that growth, coming from a low base, is feeding through to corporate profitability,” he added.
“Numerous examples can be found among European car manufacturers, with profits being upgraded as car sales continue to exceed expectations.”
But in spite of the more upbeat mood, Mr Lilley stressed that downside risks remain.
“The strength of the euro, particularly against the dollar and emerging market currencies, is now cited as one of the main headwinds in corporate announcements,” he said.
Euro tug of war
While the strength of the economic recovery in Europe is becoming more plausible with each new piece of data, there is growing uncertainty about the next movement of the bloc’s currency.
Old Mutual Global Investors’ Kevin Lilley highlighted the strength of the euro as something many companies on the continent are raising as an issue. A strong euro means firms can import goods more cheaply but exporters suffer because their goods become more expensive outside their borders.
But the tide could be about to turn.
If indeed European Central Bank president Mario Draghi (pictured) enacts ‘conventional’ quantitative easing, then the euro is likely to weaken.
Asset managers are already circling the euro, with RMG Wealth Management recently saying “it is time to short the euro not just against the US dollar but against a number of currencies”.
Also, the most recent Bank of America Merrill Lynch survey reported that 58 per cent of respondents viewed the euro as “the most overvalued currency” and stated that they expected Mr Draghi’s to likely weaken the euro.
The choice now for managers will be to join the short trade or wait for the euro to fall and catch the long one.