Morgan Stanley - European Economics & Strategy
The poor state of government finances in Europe needs to be fixed ... While the worst global recession in the post-war era is likely to be behind us, it is expected to lead to big swings in budget balances in the coming years, with EU15 deficit reaching an unprecedented level of 7.4% of GDP in 2010, according to the European Commission. Government debt is also expected to soar to 82% of GDP by 2010, an increase of ~20 %pt from pre-crisis levels. To put these figures into context, the Stability and Growth Pact (SGP) normally limits budgetdeficit to 3% of GDP and gross debt to 60% of GDP - European governments as a whole are now in ‘excessive deficit' under the SGP.
...But a tepid economic recovery alone is unlikely to restore fiscal imbalances. We believe lower trend growth will limit cyclical improvements in budgetary positions, as final demand growth is likely to be sluggish in the foreseeable future. We also see headwinds for government finances going forward - first, one-off factors such as the housing boom that bolstered public finances are unlikely to recur. Second, banking crises tend to be costly, with Sweden being the exception, as historically governments only recouped ¼ to ½ of their initial outlays. Last, there is a risk that nominal GDP growth falls short of the interest payable on debt, causing a snowball effect to set in.
Restoring fiscal imbalances requires a combination of spending cuts, privatization and tax hikes... Only very few governments have yet mapped out their consolidation strategy and most countries will likely progress cautiously with meaningful consolidation unlikely before 2011. In the euro area, "inflating one's way out of rising debt" is not an option. Instead, a combination of higher taxes, lower spending and more privatisations will have to bring fiscal positions back on an even keel. With strong corporate tax competition between different business locations and higher tax wedges being detrimental to long-term growth, we believe most of the lifting will be done via shifting the tax burden further from mobile to immobile tax bases such as labour income & property, spending cuts and privatization.
Macro implication for equities - range trading for years to come due to the threat of fiscal tightening. At some point governments will need to restore their rapidly deteriorating finances. This fiscal tightening could have large implications for equities, and is one of the main structural reasons, together with the continued need for deleveraging of the financial and household sectors, that we expect rangebound markets for years to come, as opposed to a new bull market (see ‘The Aftermath of Secular Bear Markets', 10 August 2009).
Micro implication #1 for equities - risk of potential overhang. In recent weeks, the Swiss Government has sold SFr 6bn of their stake in UBS and Norway's leading right-wing opposition party highlighted their plan to raise ~$12bn by selling their stakes in Nordic companies if they were to win next month's election. We expect more to come, as our analysis show that governments tend to step-up their effort in privatization when their finances are in trouble . Clearly, government ownership alone is not a good reason to sell a stock, as there are strategic holdings that are unlikely to be sold, and removing overhang for stocks we like fundamentally is sometimes a trigger for outperformance. However, we believe it is a prudent approach to avoid stocks with significant government ownership and negative fundamental outlook, and we would highlight the following UW-rated names - OPAP, Fortum, Hypo Real Estate, Lloyds, Commerzbank, Dexia, Norsk Hydro, Deutsche Post, Metso, SAS, Safran, Yara, Kemira, SSAB, Belgacom, Teliasonera, DT, Acea and ENEL.
Micro implication #2 for equities - potential losers of higher taxes & tighter tax regimes. Companies with low effective rates and a wide gap between domestic sales and tax exposure are likely to be the biggest losers, we believe, if taxes were to go up and loopholes in tax bases closed. UW-rated names include Richemont, Deutsche Post, Fortum, L'Oreal, Swatch, Pernod, Nokia, Actelion & TeliaSonera.
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