As the euro reaches its first birthday, it’s clear it has freed European capital to move smart and fast, writes Giles Keating
For its detractors, the creation of the euro was the forced linkage of disparate economies, storing up trouble ahead. For its proponents, it was just one building block in a broader reconstruction of Europe: political federation, free trade, deregulation, integrated capital markets and corporate modernisation – changes essential for Europe to thrive in the global environment of new technologies and emerging markets.
It will be a long time until the conflict is resolved. But, as we near the euro’s first anniversary, we have enough experience to draw provisional conclusions. The evidence supports the picture of a broader reconstruction, possibly broad enough to be described as a European renaissance.
At the heart of this renaissance is a rightward shift in the centre of gravity of European politics, away from dirigisme and towards a market-friendly attitude. The successes of liberal economic policies in the United States and Britain, and in European nations such as the Netherlands, act as powerful examples. The change is explicit in Germany and more pragmatic in France.
With organised labour and the political left wing still strong, the reformers are focusing more on deregulation of goods and services markets, and capital market liberalisation, less on labour markets, on the basis that the last of the three will have to follow.
The result is a revolution in the corporate landscape. Until now, average European returns on capital have been distributed more evenly than in the US and, within the euro zone, average returns have tended to be lower than across the Atlantic. There is a marked absence of the “super return” companies in Europe compared to the US. This is set to change as deregulation reduces profit opportunities in some areas and boosts it in others while, in parallel, structural changes allow capital to move from underperforming areas to dynamic growth sectors in a way that has not been possible in the past.
Under the old European model, capital’s movement was curtailed. Retained earnings were locked in through the prohibition of share buy-backs. Merger and acquisition activity was inhibited by the large amounts of equity locked up in cross-shareholdings, bank shareholdings and public ownership, which covered areas like telecoms, motor vehicles, banks and others. Initial public share offerings (IPOs) and debt issues were discouraged by lack of investor base, with savings going to bank deposits and bonds.
Each of these areas is now being freed up through structural changes. Share buy-backs have been legalised. Tax changes are set to encourage divestiture of bank shareholdings and corporate cross-holdings. Privatisations have increased and become much more effective. Meanwhile, there is a new appetite for European equity capital and private debt, spurred by US investors and European private pension funds.
This means that capital is increasingly able to move away from sluggish sectors and seek out the fast-growing ones. In the past, divergence in returns would scarcely have been available, even if capital had been able to look for it. Now, deregulation is eroding profitability in “old” sectors such as electricity distribution and telecoms monopolies, and threatens it in other areas of the service sector such as retailing, as pricing anomalies disappear. At the same time it is opening up new opportunities.
Links between British and euro-zone corporates are set to be among the main beneficiaries of this new freedom for capital. Despite Britain’s full integration into the European Union’s free-trade zone, the constrained continental capital markets have caused British companies to put an emphasis on merger and acquisition activity with the US, far out of proportion to the trade flows. This looks to be changing, with resulting benefits for valuations and efficiency of British and euro-zone companies.
This means more diversity of returns among European companies than in the past. Spectacularly successful IPOs and profitable merger and acquisition situations will exist alongside underperformance by older blue-chip names.
Overall, the equity markets should benefit from the more efficient use of capital and the improved aggregate earnings outlook as a more deregulated economy starts to deliver faster gross domestic product growth. The former consideration supports equity valuation by helping reduce equity risk premiums, the latter helps to boost future earnings growth.
As the new millennium begins, a coincidence of bullish cyclical and structural factors is underpinning the outlook for profitability and equity market performance. Looking longer term, deregulation and the change in capital markets are altering the corporate landscape irrevocably, making labour market reform inevitable and laying the ground for Europe to produce a group of super-return companies.
Giles Keating is chief economist at Credit Suisse First Boston