Europe’s Capital Crisis & the Ongoing Political & Economic Challenges (w/ Bernd Ondruch)


BERND ONDRUCH: My name is Bernd Ondruch.
I’m the CIO of Astellon Capital which is an
event-driven, valuefocused firm focused on
Europe with a particular emphasis on the Germanic
part of Europe.
So Germany, Austria, Switzerland.
Prior to my investment career, I was a investment
banker at Morgan Stanley for about 13 years.
So the big elephant in the room is of course,
Italy.
The situation in Italy has now crystallized
and deteriorated to a point where it’s obvious
for everyone to see that this issue is here
to stay, and needs to be solved.
And that happens at a time when we have a
major change of leadership in Europe.
Where the stewards of austerity are effectively
gone or on their way out, namely Schauble
as the German finance minister is gone.
Weidmann is effectively out of the running
to replace Draghi.
And Merkel’s days are numbered as well.
So there is this vacuum of leadership in Europe.
And all that happens while we have Italy on
the brink and run by populists.
So as far as the investment landscape is concerned,
we have seen that the only time to really
make money in Europe, and the last time you’ve
seen actually, some euphoria, an interest
of foreign investors coming into Europe was
prior to QE.
So in Q4 2014, it started to become clear
that something like QE was on the agenda.
The market started to front run the ECB into
the announcement in January 2015.
And then when it was finally enacted in March
2015, that was the only time you could really
make money from a pure beat up play in allocation
to Europe.
Ever since, the market has effectively done
nothing.
So we are 3 and 1/2 years of QE.
European markets have delivered a total return
of zero.
Obviously, a lot of volatility around that.
But that obviously makes the investment landscape
very disappointing relative to other places
around the world.
Now what has caused that is that we seem to
have one geopolitical issue every three to
six months that is so complex, that it keeps
foreign investors away.
Whether we deal with Greece, Ukraine, Turkey,
the French elections, or now, Italy, there
is always something.
And not any one of those issues is large enough
to deter foreign investment.
But cumulatively, it’s just too complex of
a place to invest and a bridge too far for
most international investors, particularly
US investors.
So when we look at flows, we can certainly
see that Europe has become a tourist destination
we’ve seen continuous outflows since the French
election in 2016.
The ultras are even larger than during Brexit
time.
And that ultimately leads to a situation where
liquidity evaporates in Europe.
We are very concerned about that across the
capital structure.
We start to see this in bonds, in sovereign
bonds.
We see it in credit.
And we see it in equities.
It almost feels like you don’t have to look
at your Bloomberg terminal before it 2:30
in the afternoon when the US wakes up.
On a sort of more longer term time horizon,
when you look at the market share of European
liquidity in global markets, Europe had a
share of roughly one third in 2000.
That has gone down to 11% So that’s a major
problem in markets.
And just to substantiate that, there’s some
sort of anecdotal evidence and some examples.
When you look at every single fund name, whether
it’s Google, Amazon, Netflix, et cetera–
every single one has a higher trading volume
than all of Italy, the entire Italian market.
All fund names combined have the same trading
volume as the entire European equity market.
And that obviously trickles down into a lot
of the mid and small caps, where sometimes,
it feels trading is done by appointment rather
than deep liquidity pools.
And that obviously has an impact on pricing.
We see illiquidity is being priced into a
lot of these names.
Political risk is being priced in.
And we see those discounts emerge across the
board.
Europe looks on paper cheap relative to the
US.
And if you look on price to book value basis,
Europe looks 2 and 1/2 standard deviations
cheap relative to the US.
But if you adjust for index composition–
liquidity, political risk, et cetera– it’s
probably fair.
One of the issues for us is that we have two
different products.
One product is a use its fund that is weekly
dealing.
So liquidity is obviously a major focus for
investors.
It seems like investors after the last crisis
are particularly concerned with liquidity.
The European market has, if at all, developed
in the UNCITS space, it is focused more on–
so say my institutional investors is a daily
and weekly dealing product, we have a weekly
dealing product.
And I’ve been constantly told by Prime Brokers
and Investors that instead of having a daily
dealing product, we are cutting ourselves
out of roughly 50% of that market.
So there is a clear obsession with daily liquidity
in the market.
Now that has a major repercussion on your
portfolio construction.
You need to be able to satisfy redemptions,
potential redemptions, on a daily or weekly
basis.
As a result, your asset side of the balance
sheet of the fund ultimately needs to reflect
that.
So you need to make sure that you can liquidate
those positions in time to honor those redemptions.
And that ultimately means that you cut out
small caps, but you even sometimes have that
in larger caps, where if trading is particularly
low, obviously, you would think the starting
point is always what is the risk-return of
a potential investment.
That’s the starting point for sizing.
But then we overlay that with a number of
technical factors, one of which is obviously,
liquidity.
And that might dictate a major cap on the
sizing of an investment position.
In fact, I would go as far as to say liquidity
is probably one of the key drivers of sizing
a position today.
I used to be a financial services banker in
my banking days.
And naturally, I would always look at banks.
I think they’re quite instructive and in terms
of telling you what’s being priced in the
market, where risk is priced, how risk is
priced across the capital structure.
So we always look at banks.
But each year, I came away saying, banks are
not interesting.
We played through the capital structure.
We were slightly high up.
Historically, we played the legacy hybrid
market.
And that opportunity was effectively harvested
in 2014.
And then was replaced by, which is still a
relatively nascent market, the cocoa market
or 81 market in Europe.
Which is now roughly 120 billion euros of
size.
That is something that we’ve played.
I believe the large opportunity is gone as
well.
It presented a major dislocation opportunity
in early when we had these issues around Deutsche
Bank.
That’s when there was a major opportunity
in that market.
But again, that has recovered, and therefore,
in my mind, this opportunity is effectively
gone as well.
Now the banks are down 25% year to date in
Europe.
Every year, and the sell side does not get
tired of recommending the banks as the next
value play.
And they do look cheap.
No matter how you look at it, they look cheap
unless you have a very negative outlook on
Europe and NPLs.
It’s well documented how large these stock
of NPLs is in Europe.
You’re still dealing with about 900 billion
obviously heavily concentrated in a number
of names and countries.
But we also have to acknowledge that European
banks have since, the crisis, every year,
added roughly 100 basis points of tier 1 capital.
So the stock of capital has clearly grown.
The loss absorption capacity is way larger
than prior to the crisis.
But these banks don’t generate any returns.
There are some banks which are interesting,
purely from a paper analysis.
They start to scream value at you.
Look at BNP for example, one of the better
run European banks.
Over the last 20 years, they’ve generated
20% ROE on average.
Guess what JP Morgan has done over that period.
11% as well.
The difference is that JP Morgan trades on
1.6 times books, attracts Warren Buffett as
an investor, versus BNP trades on 0.6 times
book.
And there is obviously a major discount being
priced in terms of political risk.
But in my mind, it also has something to do
with liquidity, and where the flows are coming
from.
And US investors are increasingly inward looking.
And as a result, we are missing these flows
over here, and those dislocations continue
to persist.
European banks now traded at 25% relative
low to the US.
So that’s clearly a sector where it screams
value, but it’s a value trap for as long as
we’ve looked at it.
I think to start with Italy, obviously, we
know what the feedback loop is between the
sovereign and the banks.
So you cannot look at any bank in isolation.
And interestingly, those feedback loops are
starting to increase.
We recently looked at the flows in BTPs again.
Since 2015, there was only one marginal buyer
of BTPs in Italy, and that was the ECB.
Everyone else sold into the ECB, whether it’s
domestic banks and insurers, private households,
or foreign investors.
That has changed since the repricing of BTPs
early in the year in May.
The Italian banks are started starting to
buy BTPs again for the carry, of course.
And we’ve seen what that does and in Greece–
when they soak up so much of the domestic
bond market, that ultimately, the feedback
loop becomes even stronger.
And therefore, we have a relatively negative
outlook on BTPs and in Italy in and of itself.
So therefore, I think the Italian banks, they
are cheap on paper, but we wouldn’t touch
them.
The Spanish banks are a different story.
I think some of the names there are extra
exceptionally well-run.
Banks like Caixa and Santander obviously extremely
well-run.
You know, you look at Spain versus Italy today,
Spain trades at roughly 100 basis point spreads
versus bonds in Italy at 300 basis points.
If that spread moves to 400 basis point, that
seems to be the red line in the market where
Italian politicians and the market will ultimately
go into panic mode.
We’re not too far away from that scenario.
The German banks are– well, I spent 13 years
of my professional life trying to make a living
out of consolidating a market which is notoriously
over branched and over banked.
Over 2/3 of the market dominated by local
savings banks and mutuals that don’t have
a primary profit focus.
And as a result, the entire market is structurally
less profitable.
I wouldn’t say massively unprofitable, but
certainly, less profitable.
Now if you look at the major banks around
the world, they have all one thing in common,
which is a dominant market share in their
home market.
That’s where they generate the cash flow to
ultimately invest overseas.
Look at UBS, look at JP Morgan, look at HSBC–
those banks have a domestic market share that
generates that cash flow.
Deutsche Bank does not have that.
Commerzbank doesn’t have that, and they never
had it.
And even if they merged, they won’t have it.
So the market remains structurally challenged.
And I think this is going to be another–
there will be other careers that will be wasted
on trying to consolidate that market.
The progress is just way too slow.
You know, the conclusion of 2016 has been
the 81 markets started to set up a major booby
trap for Deutsche Bank.
They reported large losses under IFRS.
The question mark what was what that meant
under and the local GAAP.
But the critical issue was, was there any
coupon paying capacity at Deutsche Bank.
And that ultimately repriced a small part
of the capital structure, namely the 81s,
and ultimately set up hedging activity in
the CBS market, and obviously, shorting activity
in the equity market.
And you know, Deutsche came close to some
form of state intervention.
It’s clearly been discussed.
Now that issue has parsed Deutsche, that did
yet another capital raise at the time.
But it has never really gone away.
The stock is now still trading at an all time
low, 28% of book value or whatever book value
is.
All the rights issues are effectively gone
in terms of the market cap destruction at
Deutsche Bank.
One of the scenarios that is being discussed
and I think is being supported now, if not
sponsored by the German government, is a potential
merger of Commerzbank.
The German government is still invested in
Commerzbank since the crisis.
A potential merger would ultimately make them
end up to be an anchor investor in Deutsche
Bank as well.
From an industrial perspective, that makes
sense.
We all know that in market mergers create
most energies.
As a rule of thumb, I think you can argue
that 30% of the cost base of the smaller target,
which is Commerzbank in that case, can be
eliminated via cost savings.
And the NPV of it is significant.
It’s almost as large as the market cap of
Deutsche Bank.
So there is a potential value opportunity.
But given the size of the balance sheet, given
the risk attached to the balance sheet, the
skepticism around the balance sheet.
But even equally important, the question mark
about, what is the future revenue potential
of someone like Deutsche.
I think this deal is probably another two
years away unless we have a crisis and a state
of emergency.
I remember a meeting with Jo Ackermann when
he was still the CEO of Deutsche Bank.
That must have been around 2010.
During the meeting, he told investors that
regulation had peaked in Europe.
Now eight years later, we might start to think
that actually, regulation has peaked, and
we’re going to let it play out.
At the same time, I think the market looks
at this slightly differently and believes
that any recovery in banks will ultimately
be used to raise the bar again.
So I think it’s premature to call an end to
regulation in Europe on banks.
And I think that makes this sector ultimately
uninvestable.
We don’t know what the regulatory framework
will be for a longer period of time.
And as a result, it’s very difficult to understand
what the returns of these banks will be.
And therefore, something like Deutsche Bank,
which now trades at 28% of book value, looks
to me as a deep out of the money option, but
not like an investment case.
It’s just too binary.
I almost sound like a broken record.
One sector that I continue to like and have
liked since effectively since the inception
of the fund, is the German real estate market,
both residential and commercial.
I’ve talked about this on a previous interview
about the narrative and the fundamentals behind
that sector, and this continues to play out.
The sector is consolidating.
We have now very illiquid names in that market.
Some of them are included in the DAX 30 companies.
But importantly, the fundamentals are still
intact.
And these companies are relatively easy to
analyze.
So let’s say take Deutsche Wohnen, for example.
Deutsche Wohnen resulted as a merger of a
number of companies that we’ve been invested
in.
It is now the second largest residential player
in Germany.
The market cap is around 14 billion.
So large enough and liquid enough to trade.
But importantly, they have roughly 70% of
their assets in Berlin.
And Berlin continues to be the hot spot in
continental European residential real estate.
Rents are rising at roughly 2x of inflation.
These companies are refinancing at virtually
zero.
There is a clear value opportunity that these
real estate companies are harvesting.
And while it has become a major political
issue on the domestic agenda as far as increasing
rents and affordability is concerned, none
of those political initiatives or even macro
prudential measures have really kept the market
under control.
What needs to happen is more supply needs
to come into the market.
And that doesn’t take place.
And it’s quite simple why that is the case.
If you build new today, buying land plus property
costs you– building costs, that is– cost
you roughly 2,600 to 3,000 euros per square
meters.
You can buy something like Deutsche Wohnen,
where you look at their portfolio, where these
properties are valued at roughly 2,000 euros
per square meter.
So unless that converges, and unless there
is more supply coming into the market, the
values of these real estate names will continue
to go up, while rents keep increasing at roughly
twice the rate of inflation.
So in my mind, this is still a relatively
safe bet that has delivered to us roughly
20% compounded returns over the last six,
seven years.
And I believe the upside continues to be in
those names.
Outside of that particular sector, I find
it very difficult to see value in Europe,
particularly looking at some of the growth
names.
The growth proxies or growth avatars that
we have in Europe are mainly dominated and
are residing in the small and mid-cap space.
These are not necessarily large disruptors,
but these are of growth companies that compound
10% to 20% annual revenue growth.
We looked at those names for a number of years.
We consider them to be expensive last year
when they were trading between 30 and 40 times,
only to see them go up to 50, 60 times earnings
this year.
And by no means these are great companies.
They have many attributes that we like.
But at 50, 60 times earnings, we simply consider
them consider them overvalued.
So we continue to tell our investors we can
see those names are going up.
We think they are expensive.
We considered them expensive for quite some
time.
You cannot really short them because there
is a vault of money chasing those few names.
And therefore, we won’t participate in those
names.
Those names have obviously rallied for the
better part of this year only to get decimated
in October, where a lot of these names you
know have effectively collapsed.
And that’s a major reason why we never wanted
to touch these names, because we felt that
you can wake up one day, and these names are
down 30% 40% on a profit disappointment.
That’s not what we want to do.
So as a result, we stayed away from these
names.
And I think many funds that ultimately have
capitulated and have been crowded into those
names had a rude awakening in October, where
the illusion of positive performance year
to date was effectively gone and in a matter
of days or a couple of weeks.
As I said, we are now in a vacuum.
And I believe this vacuum is going to remain
in place for at least another 12 to 24 months.
Macron is today, probably the only leader
who is making active proposals for Europe,
none of which has been responded to by Berlin.
And for as long as that remains the case,
we see very little progress in Europe.
Having said that, we can start to see a picture
emerging whereby Europe will ultimately have
to go down the fiscal spending route.
And the narrative is being painted by no other
than Merkel herself.
She’s given speech after speech where she
has pointed out that Europe can no longer
rely on the US as far as defense is concerned.
So that speaks for more defense spending,
border control, the immigration crisis.
All of that requires large investments, and
that could ultimately create the narrative
for more fiscal spending.
Today, there is no political willingness to
do that.
But eventually, once we have a change of leadership
in most governments, and once Merkel is gone,
for example, I think we will ultimately have
to go down this route.
And that will be, I think, the next time international
investors will start to look at Europe in
a more serious way.
The German equity market has primarily benefited
from the investment boom in emerging markets
and China in particular.
And many of those companies have exported
you know effectively, their technology into
China.
So the more China started to stimulate their
economy by credit growth, Germany benefited
from that.
Conversely, we see this year as credit growth
starts to slow in China, demand is falling
off.
And we start to see for the first time for
example, negative sales growth in auto sales.
And that has obviously, repercussions throughout
the entire value chain.
You talk to some of the camera companies,
you talk to some of the other suppliers, they
start to see that growth is starting to fade.
Now based on our estimates, roughly 30% of
EBITDA growth over the last six years is responsible
by China.
So as that credit engine starts to stutter
in China, Germany is heavily exposed.
And that’s what we see now.
Germany is now trading at a relative discount
to some of the broader European market.
And the more these Chinese issues or global
growth issues surface, I think Germany will
be the go to place for sell offs and shorting
Europe.
So my view on Italy is– maybe as a bit of
background, where this has been derived of.
We’re obviously a very event driven, value
focused, single name shop.
We don’t necessarily play macro themes.
However, I think all asset managers have ultimately
evolved, including us, and we have included
as part of our framework, a fund engine over
the last few years that has helped us to steer
the funds better through these rotations and
factor exposures that have emerged over the
last few years.
We’ve seen this in particularly in 2016, where
some of our names, even if they’re not particularly
rate sensitive, even industrial names, retail
names, even chemical names, have started to
exhibit large duration exposure in the portfolio.
And we initially started to hedge that exposure
by shorting bonds, which we considered completely
overpriced at that point.
In fact, we always made the point that anyone
investing at zero or negative rates is violating
their fiduciary duty to its investors.
But as we started to extend that analysis
and looked at are there maybe better options
to play that, we started to look at BTPs in
Italy.
And then we felt we get the same as in shorting
bonds, i.e. we can short duration.
But on top of that, we got a free option in
shorting a potential credit event.
And that’s two years ago when we started to
look at BTPs.
And we considered at the time, that the risk-reward
was particularly unattractive for BTPs.
In fact, we considered the risk-reward to
be 1 to 10.
Now we’ve done a lot of work around that.
And we always felt that Italy– the issues
in Italy came from the 1980s, 1995.
That’s when they accumulated large parts of
the debt.
Since then, it’s obviously debt servicing
costs that have contributed to that and low
growth.
We then started to take a closer look into
you know who is buying BTPs, what are the
political challenges.
And about a year and a half ago, I was invited
to Rome.
To a Senate in Rome, where they had a full
day– it was the Five Star Movement– laying
out their potential debt restructuring plans.
And they made it pretty clear to the world
that they understand the dynamics of their
debt.
They have roughly 95% of their stock of debt
is based on local law.
So by decree, they can change the terms and
conditions of outstanding bonds.
That makes Italian bonds particularly unattractive,
because you could wake up in a populist government
altering the terms and conditions of bonds.
Not just by maturity extension, but potentially
coupon holidays, et cetera.
And therefore, we consider those bonds, particularly
unattractive.
Now that was all public.
And I think the analysis was pretty complex,
but ultimately, it became a consensus about
a year and a half ago.
Nevertheless, it took another year– we were
short these Italian bonds for the better part
of a year, and nothing happened.
And it was pretty clear the ECB will ultimately
go down the tapering route towards the end
of the year.
Draghi will be out by next year.
There was a populist government in power.
Why would you own BTPs?
Ultimately, the government was already in
power when we had a repricing event that lasted
effectively three days.
That’s when BTPs repriced.
In my mind, this is an example of what’s going
to happen with most asset classes.
There’s this large complacency until it finally
happens, and then it’s too late to get out.
Now in our case, we needed to wait a year
and a half to make this a profitable trade.
But we’re seeing it now in growth stocks as
well.
I mentioned some of those European growth
avatars.
There was this illusion of profitability of
those trades for the better part of a year,
and it was all gone in a matter of a couple
of days and a couple of weeks.
And I think Italy is now at a point where
in my mind, they will find a compromise with
the EU.
But they’re playing the long game.
I think it’s naive to believe that the Italian
government is just a populist government that
delivers soundbites.
From all I’ve seen of some of the characters
involved, I would say they’re extremely well
advised.
They’re completely clued up about their potential
options.
I think they’re also clued up about the potential
to leverage their position vis a vis the EU.
And that at a time when Europe is focused
on who’s going to lead you into the next area,
I think that gives ultimately, Italy an opportunity
to cut out some pound of flesh from the EU.
Having said that, at 3.5%, I think these bonds
are still a good short for the long run.
But now we need to wait.
A large part of the duration event, I think,
has taken place.
Now the credit option needs to be priced in.
And we’ve seen it in the example of Greece.
Typically, that repricing of the credit option
takes place one to two years before the restructuring
is ultimately taking place.
I wouldn’t necessarily wait until the restructuring
is being announced.
I think at that time, it’s way too late.
Typically that starts way earlier.
My view is to keep your powder dry, and to
be ever more selective.
And that means obviously, in every market
environment, there are opportunities, many
of which are situational, very idiosyncratic,
and you can do that.
But for a broader diversified portfolio, my
recommendation is actually to stay away.
The risk-reward is still very unattractive.
Now the recent sell off has been exacerbated
in some segments of the market, and particularly
in the small and mid-cap space, where we’ve
seen some stocks fall off 50% to 70%.
But there’s still downstream value yet, because
I think the flows will not come back to these
names for quite some time, unless we see more
progress in Europe and European equity markets
in particular.
So my view is actually, we are now switching
into a phase where ultimately, the bubble
in sovereign bonds has been in my mind, the
authentic bubble in the investment world.
And as a result, cost of capital have been
depressed.
And as rates back up, and as we see the script
of central banks to increase rates further
in the US, and the ECB actually getting out
of QE, the cost of capital will continue to
go up.
That will ultimately mean a multiple compression.
We’ve seen this already this year.
European markets have compressed by 1 and
1/2 turns.
And that will continue, in my mind, next year.
On top of that, I think we will go into an
earnings recession next year.
Growing earnings this year and in a relatively
benign environment by roughly 7%.
But no matter where you look, input costs
are going up, labor costs are clearly going
up.
Margin pressures coming in.
When you look at outlook statements, particularly
now on the back of Q3, what European companies
have reported, I think the uncertainty as
far as the business cycle is concerned doesn’t
speak to particularly strong earnings growth
next year.
In my mind, we’re going to see an earnings
recession.
Coupled with QE is going out.
And I mentioned earlier QE has ultimately
been around now for 3 and 1/2 years, and European
equity markets had a total return of 0 over
that period.
It is very unlikely, in my mind that equity
markets will progress in general, once you
get out of QE, and cost of capital will go
up.
So as a result, in my mind, I would wait for
a proper correction next year.
I think we got a little bit of a taste of
that this year.
But next year, we will probably see a larger
correction.
And at that time, I would start to deploy
capital again, and wait for the next business
cycle to trade.

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