The most striking structural issue facing investors at the moment is the low growth rate of the Eurozone. Both China and the US seem fairly resilient in their own very distinct ways, but Europe seems mired in deflation and really very low growth rates. Obviously, these rates vary within the Eurozone but overall Europe looks more than a little anaemic.
Understanding what’s going on involves examining a series of overlapping issues such as an ageing population, inefficient fiscal and monetary policy and of course the behaviour of corporates within the Eurozone. A bunch of charts I dug out from a report by analysts at Morgan Stanley on private equity might contain some hint of an answer. The first is the weighted average cost of capital which is near all-time lows. This suggests that cost of capital and perhaps access to capital (for larger corporates) isn’t an issue.
BUT this low cost of capital might also be implicated in another phenomenon – return on equity is also declining. The driver here is in effect stagnation. Low-interest rates are a result of low growth rates and low inflation. This, in turn, feeds through to slow earnings growth and low returns on equity. The chart below again from the MS report on private equity suggests that M&A activity is down substantially because Return on equity in Europe has been declining for some years.
But maybe we can’t entirely blame corporates for this behaviour. Maybe ‘conservative’ institutional investors have played a role. As public markets have become increasingly momentum-driven and short termist, investors have started to punish businesses that spend too much on capital investment.
On one level this behaviour is not entirely unjustified if the return on equity is low – why invest in more capital if returns from that investment are so low? But how will corporates break out of a cycle of low returns if they don’t burn through some capital to increase productivity rates? By contrast, this market behaviour seems to reward those businesses which hit or exceed their earnings expectations targets. In sum, Europe seems trapped in something of confidence and returns trap, exacerbated by low-interest rates and ‘conservative’ institutional investors – and corporate elites happy to play cautiously.
Key takeaway from the chart below – public markets punish businesses with high Capex