Reading Time: approximately 10 minutes. Click here to read this letter in PDF Format. Dear…
Europe is the world’s consensus short. One need not look too hard to find news stories about the instability of governments all over the continent, rising populist movements and “stagnant,” economies. This view has been well honed by economists, thought leaders and the global “elite.” In the run-up to and in the wake of the Italian referendum, there have been innumerable attempts by Wall Street commentators to talk about the “next domino” to fall and how a failure of the Renzi government to convince the Italian population of the need to reform would cause imminent doom and gloom. These views were well-baked into market expectations, which is why in the wake of the “worst case scenario,” outcome in the Italian referendum, European markets have actually rallied – including Italy’s. Of course fluid political environments are nothing new for Italy, having had now 66 governments since the end of World War II. In fact, Italians have shown a predictable skepticism against increasing the strength of the government, with Berlusconi’s similar electoral reforms defeated by nearly the exact same margin as Renzi’s political reforms exactly a decade later. With President Mattarella asking Paolo Gentiloni to form a new government under the same electoral coalition that Matteo Renzi relied upon, it looks to us that within a matter of a few weeks and some fresh capital injections into a couple of weaker Italian banks, Italy will soon return back to business as usual rather than the nightmare political vacuum markets had priced-in.
In the wake of Donald Trump’s surprise election in the United States, investors have concluded that similar anti-immigrant populists everywhere will win elections and disrupt economic progress. Marine Le Pen, the leader of France’s National Front, may steal a lot of headlines with her promise to hold a referendum on France’s membership to the eurozone, but these headlines are simply a sideshow to recent political developments which have seen Francois Fillon to emerge as her top contender, a candidate whose policies look much more similar to Trump’s than any other in France. And he’s not just a top contender, but has opened up a commanding 32% lead in recent polls. While polls have become less reliable lately, a lead this large is well outside any heightened margin for error. Yet despite these polls, populist parties in Europe have stolen most of the headlines which has catalyzed a herd-like withdrawal of international investors from European equities.
Exhibit 1: Weekly European Equity Fund Flows ($ in billions)
Source: DB, EPFR
The world remains significantly underweight peripheral European securities at a time when easy monetary policy is keeping heavy pressure on the euro foreign exchange rate, which has been a boon for international European companies. This increase in competitiveness relative to their US counterparts will only continue to widen as the European Central Bank has committed to more Quantitative Easing for a longer period while the US Federal Reserve is poised to continue raising rates throughout 2017. This will continue to be a major theme for the year ahead as Europe goes through its own electoral season.
Exhibit 2: Cumulative Equity Fund Flows in the Last 12 Months
Source: DB, EPFR
While the populist parties in Europe (who typically make the most outlandish, and headline-grabbing statements) occupy the majority of newspaper headlines and investor attention, a more quiet and conciliatory free market slate of candidates stand poised to win this vital electoral season. France’s Fillon has a free-market agenda that would unlock a stagnant French economy by reducing regulations, promoting longer work weeks, lowering entitlements, reducing the importance of unions, and lowering French government spending outside of defense. Proposed policies include a reduction in numerous taxes, including corporate taxes, and a complete re-writing of labor laws. Yet the market is largely unaware of such a positive outcome being remotely close to possible. As such, as polls currently predict a landslide run-off election in which Fillon will likely become the next President of the Republic, the French market is set for a far more dramatic response to such a win than that of the US market in the wake of Donald Trump’s election. The major difference is that Fillon will be inheriting an economy that has been subjected to nearly a decade of economic stagnation as more regulation, lower incentives to work and high government entitlements have held back economic activity far below potential normalized levels.
Exhibit 3: Expectations vs. Reality in France’s Upcoming Presidential Election
Source: GreenWood Estimates based on qualitative and quantitative factors.
Thus, while the market is currently expecting a high risk of a protectionist or anti-free-market outcome in France, the recent polls published since Fillon’s win of the Republican primary have suggested that the Presidency is in the bag for the free-market candidate. Almost reliably all year, the market has mid-judged outcomes relative to the underlying reality. We understand polls have been terribly wrong, but the market has even misjudged the outcomes of the outcomes. For traders focused on making short-term profits, this has been an incredibly taxing and difficult year, with unexpected outcomes happening repeatedly. While the juxtaposition of Fillon relative to outgoing President Hollande is less dramatic than the Argentinian example, we believe a Fillon win for the country would be akin to the assumption of the Presidency by Macri from Kirchner in Argentina’s 2015 elections. While less of a boon for free-market and economic policy, Brazil’s impeachment of its President and later assumption of the office by the Vice President represented another positive political step for a country that has been running far below economic potential. These two examples are actually important because both markets were among the worst performing global indices in 2014 and 2015, particularly in dollar-based measurements. They both have become the top performers of 2016, but the market’s positive returns didn’t wait for the new candidates to assume office, as the markets climbed in anticipation of a more favorable resolution in both cases.
Exhibit 4: Market Returns Around Elections & New Governments
Data Source: CapitalIQ
Both the Argentine and Brazilian elections and market developments give us cautious optimism going into the European electoral season. Despite Italians voting against Prime Minister Renzi’s proposed electoral reforms, Italy’s anti-European party, the 5 Star Movement, has not gained popularity in the country in recent months. In fact, most Wall Street “strategists,” were simply incorrect in rushing to judgement and claiming that the defeat of the reform will help 5 Star Movement seize control of government eventually. The rejection of the electoral reforms has allowed the President to request the next Prime Minster find a coalition to support the re-writing of the electoral law, and the country’s constitutional court will opine on a controversial still-standing super-majority component to the Renzi reform on January 24. The honest truth is that a full-scale adoption of Renzi’s ill-conceived (he later admitted this as well) electoral reforms would have made a 5 Star government actually more likely, not less likely. Even with Italian banking capital shortfalls not completely resolved, the Italian market has staged a slight rally in the wake of this result, suggesting market expectations had become far too pessimistic ahead of the important European electoral season.
The same night, Austrians voted unexpectedly to reject the country’s far-right and anti-Euro party in its Presidential election. This echoes Spanish voters shifting support slightly away from the Podemos anti-euro party in elections during the summer. Despite Marine Le Pen and 5 Star Movement grabbing a lot of headlines, their popular support has had very little momentum in the back half of 2016, with 5 Star support actually deteriorating in the polls in the last six months. This would come as complete shock to market “strategists,” who see the political climate in Europe as toxic. We disagree that the European political environment has become toxic – merely, some of its minority actors have become more and more extreme in their rhetoric as they perhaps seek to replicate the success of a certain reality-TV celebrity who recently won a major election.
Francois Fillon has a strikingly similar platform for President than did Donald Trump, with the exception of the protectionist trade policies – policies which the President Elect has already partially backed away from. In hindsight, not only did the protectionist measures help Trump win rust-belt blue states, but the rhetoric also improved his ability to negotiate more favorable trade terms with our trading partners. Even a cursory glance at Trump’s business history will make obvious that much pomp goes into his negotiating tactics, and the trade talk follows his classic, “art of the deal,” pattern. The combination of labor market reform, lower taxes and lower regulation is a free-market cocktail that could unlock a significant pent-up recovery for France. Even the social policies of the candidates look fairly similar, which would help appease voters attracted to Marine Le Pen’s extremist views on nationalism and immigration policies. It’s important to note that polls have been less reliable in an age of embarrassing political choices and an evaporation of traditional communication methods, and furthermore only two major polls have been conducted in France in the wake of Fillon’s winning of the Republican primary, but it looks like France may just have a Trump card up its sleeve. As Europe climbs its way out of an important electoral season, we’d expect this year’s worst-performing markets in the world to look quite a bit similar to 2015’s worst performing markets in this past year.
With Berlusconi looking to re-assert political influence in Italy’s next elections, global investors could be looking at a sea change of governments away from the 2008-2015 protectionist, regulation-focused and socialist governments in most G20 countries and towards those that emphatically support free market principles. The markets that stand to regain the most lost ground in this outcome would be those economies, like Argentina, that have faced the most protectionist and stagnant economies over the past decade, coupled with markets whose low valuations rhyme with such a miserable situation.
The trouble for many global investors is that navigating “peripheral” European markets can be like going into the territory that was once marked “Beyond here, there be dragons,” on most explorers’ maps. We believe the key to sound investments in these markets correlatives overwhelmingly with the quality of the company oversight, particularly in France, where we’ve known more than a few boards to make decisions based on ulterior motives that sometimes leave shareholders scratching their heads. Bolloré is one of our favorite Franco-Italian stock picks and we think it’s particularly a well-timed bet heading into 2017 for more than just French electoral and market reasons. We think most of its units that have faced tough 2016 trading conditions are poised to significantly recover in 2017, and the discount to net asset value has rarely been wider.
Ironically Bolloré, both the man and the group, have ties to Silvio Berlusconi, a man who invented the modern bombastic and egocentric political career for billionaires that seems to be sweeping the rest of the world. Despite all the flaws of the man, he managed to govern Italy for just under half of the last two decades. Some international commentators may question how the man has continuously resurrected himself out of the political and scandal-ridden ashes, but it can be summed up with one simple fact: the country had average unemployment of 8.1% during his tenure compared to the 10.4% average experienced in the non-Silvio years. His tenure also paradoxically includes the financial crisis of 2008-2010, making the comparison even more dramatic. Heading into 2017, as we anticipate unquestioned resolutions to French, German and Italian political situations, with voters emphatically tired of a moribund economy with stagnant wages, we believe the free market politicians will continue to retake the political mantle from the prior regimes. American, Argentinian and Brazilian market valuations already reflect rising expectations of growth and pro-market reforms. French and Italian markets reflect ongoing despair and capitulation. We think it’s a great time to be looking for treasure amidst the rubble, for by the time spring rolls around, the French and Italian political outcomes will be very well understood. And as Warren Buffett has wisely noted, “if you wait for the robins, spring will be over.”
This article has been distributed for informational purposes only. Neither the information nor any opinions expressed constitute a recommendation to buy or sell the securities or assets mentioned, or to invest in any investment product or strategy related to such securities or assets. It is not intended to provide personal investment advice, and it does not take into account the specific investment objectives, financial situation or particular needs of any person or entity that may receive this article. Persons reading this article should seek professional financial advice regarding the appropriateness of investing in any securities or assets discussed in this article. The author’s opinions are subject to change without notice. Forecasts, estimates, and certain information contained herein are based upon proprietary research, and the information used in such process was obtained from publicly available sources. Information contained herein has been obtained from sources believed to be reliable, but such reliability is not guaranteed. Investment accounts managed by GreenWood Investors LLC and its affiliates may have a position in the securities or assets discussed in this article. GreenWood Investors LLC may re-evaluate its holdings in such positions and sell or cover certain positions without notice. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of GreenWood Investors LLC.
Past performance is no guarantee of future results.