Some 61 metres from The Monument, which raises since 1677 in the City of London as bystanders' reminder of the Great Fire, there is Pudding Lane and the location where the flames in early September, 1666, crawled their way towards the financial district. It ended mostly reduced to ashes.
The East wind had spread them over the wooden-pitch houses of Fish Street and Gracechurch Street. Here, I met this week the lead portfolio manager of the £470-million Royal London European Growth fund, Neil Wilkinson.
How would a Grexit affect the City?
It will totally depend on what firewalls are in place to stop contagion spreading to other economies. I sense the language of [German Chancellor] Angela Merkel has softened towards Greece in recent weeks. Is it inevitable? I suppose it is possible but I don’t think it is inevitable.
The political will to keep the euro zone intact is very, very strong, and I think the softening of tone is an admission that if you did let Greece go, it might not be able to stop other countries falling out of the euro also. If you have been saying for many years that a breakup is not possible and then it happens, you have no credibility.
How has the euro fire changed your job?
In the last years? Well, let’s take it back a little further, because it’s interesting to look back at this. I have been running money for European equity during the last 13 years, and I think you can break it down into two very distinct periods: pre-2008 and post-2008.
Now, pre-2008, my investment style was very much driven by stock selection. There was far less consideration of politics, nor as great a degree of influence from macroeconomic factors. There was very little differentiation between a listed company based in Germany and a listed company based in Spain. You’d look at them on their individual merits and where they were domiciled didn’t come into the equation. I was fairly agnostic on country exposures, other than my net currency exposure to Scandinavia and Switzerland, in which case I needed to be aware of my position, however other than that I was agnostic about where the companies came from.
This has changed significantly in the last couple of years, where companies with similar qualities, generating similar returns—in terms of their operating returns, their returns on capital—are being treated differently because of their domicile.
So, let’s say, before 2010 you weren’t much aware of the imbalances affecting the euro zone economies…
No, no, I wouldn’t say I wasn’t aware of those imbalances… As a portfolio manager, if you look at what drives returns, at that time they were driven by stock specific issues and by sectors rather than by their domicile. Country risk was something we really didn’t consider as portfolio managers until 2008 onwards, and increasingly so since 2010. So I wouldn’t say we are unaware of the imbalances, because we all could see that economically there were some unsustainable trends, but within the equity markets, returns weren’t driven by where the corporates were based. Clearly, that is not the case nowadays.
That is, now when you check on Telefonica or Santander, the fact that they have a strong link to Spain, immediately introduces an element of distortion.
It has an impact on your investment decision, yes, which it wouldn’t have done five or six years ago. Because, quite simply, the debt that these companies have in the market is going to be is going to be related to the sovereign debt and when bond yields are high it’s not going to be good for them.
Is it fair? Does the City panics too easily?
(Smiles) Is it fair? Oh well, that is a common question. Is it fair?, not in all cases. There is not a straight answer to that. It is fair for the banking system, because there is a relationship between a bank and its sovereign, so it is justified that you have a correlation between sovereign and a corporate there.
But I could also give you some examples in Spain where I do not believe it is fair, where the domicile has had an impact on the share price, and that is often an opportunity to buy into companies at, I think, very attractive prices.
My first example is Ferrovial, which has very limited exposure to the Spanish economy, with 75%-80% of its business is overseas. It has got some fantastic assets, like BAA and the Toronto ring-road, assets that are generating above inflation index-linked returns year in year out. The parent company has a very strong balance sheet, and yet the stock price performance through the first half of the year was very poor. I invested in the company two to three months back when I believed the fair value of the business was some 40 or 50 percent higher than the prevailing share price, and I felt this was a company that was being punished purely because of its Spanish listing.
Another business I’ve been investing in for a quite some time now is Grifols. Now, Grifols also has a very high proportion of its business outside Spain, but in this case the share price hasn’t actually been punished, and in fact its has done phenomenally well this year because the business has been performing admirably.
Now that you mention Grifols, do you think it would make a difference for Catalonia-based companies if Catalonia’s indepedentists had it their way. You mentioned before that politics have become part of the coordinates that you check when allocating capital.
I have to admit that I’m not an expert of internal politics within Spain. However, I’ve been led to believe that it is a very remote possibility to think that Catalonia could actually go independent from Spain. But I’m relying on my Spanish contacts to help me here.
Put it in a different way: I cannot imagine that a situation where London sought to become an independent state within the UK even though its economy subsidises the rest of the country, which it does. I realise there is some historical background and that it there may be a greater degree of desire for independence within some Spanish regions, but I think if anything we’re moving towards greater centralisation within Europe rather than decentralisation and smaller governing areas.
Would that be, more or less, the general impression in the City? Or perhaps isn’t really talked about?
To be honest, it’s not really talked about. I don’t think it is a source of undue concern, it’s rather one of those things that may get talked about in periods of economic stress.
It hasn’t worsened your views on the Spanish economic.
No, no, no. Not at all. I think the main question for an investor looking today at Spain is when and if there is a bailout. There is a speculation that it could happen now that the regional elections have been held.
The second issue I am dealing with at the moment concerns how realistic the government budget for 2013 is: the Spanish government assumption is a -0.5 percent fall in GDP, and that is a some way above consensus, which is -1.3%.
Is that the weakest point in the budget or there are others to add to that list of doubtful expectations?
Yes, I think that’s the main concern. There might be others but if you don’t hit that growth target or, in this case, if the decline is worse than what they are modelling, then clearly the deficit target is therefore at risk.
I read the other day a fascinating article looking at correlation between austerity programmes and the impact on the GDP. The reason why austerity has been pursued in Europe is that historically it was succesful. If you tightened your fiscal budget by 1 percent, it would typically have only a -0.5 percent impact on your GDP, so you could actually tighten yet at the same time it wouldn’t damage your economy that badly. It worked because the global economy was far less interlinked. There were always regions to which you could export, regions that were growing, you obviously were in control of your own currency, so naturally two or three years down the line your GDP growth rate could recover.
The issue we’ve got today is manifold and different. Firstly, the correlation between how much you tighten and the resulting GDP impact has actually increased and it’s actually 1 to 1 in major countries, and it’s been statistically close to two in Mediterranean countries, so as countries have tightened it has actually accelerated their GDP decline.
There are a couple of reasons for that. Firstly, the whole world is slowing down at the same time so there is virtually nowhere you can increase your exports to, and secondly countries are locked into an inappropriate currency level.
When the Spanish minister for the Economy de Guindos recently visited London, he highlighted how Spanish exports have expanded in a remarkable way…
Yes, it has picked up, yes.
…and it would show how the Spanish companies are successfully competing out there.
Yes, but is it enough? There have been some adjustments rightly made, and I do appreciate that numbers are looking better—this very morning I was talking to a Spanish broker and we commented on exactly that—, but it’s not reflected on the GDP yet.
It obviously helps, but perhaps isn’t strong enough to drive actual nominal GDP growth, and that is what ultimately countries who are going through austerity need to be able to repay their debts.
Mr de Guindos also said that the situation of the overall Spanish economy is better than reported elsewhere and there is no urgency at all in requiring a bailout. I must say that the audience was surprised by that, and some people even laughed.
Very politely, but they did. Had the minister told that to a group of fund managers, would have he received the same answer?
I read it in the news. To be honest, well, it was interesting, the timing of the conference, because it was after Draghi’s speech, wasn’t it? Draghi said that the announcement the ECB made about buying unlimited quantities of bonds of countries aided by the EFSF or the ESM has already taken some of the stress off the bond market. And it has, clearly.
The unknown is, if Spain or indeed any other economy doesn’t go for a bailout, will the bond market test those 7 percent yields again, and force them to go to the ESM? Or just the permanent threat—if threat is the right word—of the ECB coming into the bond market actually puts a psychological cap on bond yields anyway.
We are in no man’s land now. It’s very difficult to say where the market is going to go.
And in the sense that equity markets are today correlated bond markets, isn’t it problematic for investors? Doesn’t it show a gap in understanding? Because investing in a country isn’t the same as investing in a company. A country, let’s say Spain, in need of structural reforms, is going to need time and investors seem to lack patience.
Any supply-side reforms that do go through take a long time before they have an impact in the economy. For example, the reforms of the Britain of the late 70s/early 80s took several years to take effect, as did Germany of the early 90s, so you are not going to get an instant fix.
I think what we need, though is improving data in the US, which are now seeing, and once we have a new government installed in China with further stimulus measures undertaken there first quarter next year, then there could be, and it’s a could because we are very finely balanced at the moment, enough momentum globally to help pull Europe out of the trouble it’s in. It will be slow, and it’ll be painful, and GDP growth will be below trend for a number of years, but I’ve always believed that there will always be a way to muddle through, that’s the best way to describe it.
My impression has lately been reinforced that there is so much political will behind the euro and greater integration of the euro economies that I’ve got confidence that the euro in its current form will survive. I wouldn’t have had this degree of confidence some months ago, but I genuinely believe that there will be a way out.
That’s not to say I think the system is right or wrong.
Have investors become aware that it’s going to take longer that thought before for the euro zone to stabilise its situation?
You won’t find any fund manager in London who is overly optimistic or would forecast significant growth in the euro zone for the next year or the year after. What is important to remember though is that European equities are trading at a significant discount to other developed economic markets in the world, which makes them attractive. If we go down the road of the ‘muddle through’, and various measures are taken to keep the euro zone intact, then we can expect several years of below trend growth, but there are still plenty of opportunities to find companies at very attractive prices, who are able to grow through exporting to the US and Asia.
We all recognise that the income situation is quite difficult, but at the same time our market is very reasonably priced and there’s still plenty of opportunities to get growth forward, and that doesn’t exclude opportunities in Spain, too.
You mentioned that you talked this morning to a broker in Spain. What are your sources of information there?
I have a network of local brokers in each of the countries that I cover as well as London-based investment houses and international banks. Coverage of the very large caps—let’s say Telefonica, for example, is made in London as well as Madrid, but for additional, on-the-ground information, particularly moving down to the medium or small cap level, it’s quite important to have local contacts.
So you get information not just from The Daily Telegraph and the Financial Times.
Correct. The majority of fund managers will speak to local contacts, or indeed visit the countries by themselves. For example, my investment in Ferrovial came about following a meeting with its management, in which I had the chance to question them on their strategy. I also looked at the valuation of the business, then read external analysis, and took independent opinions.
Is there a monolithic opinion in the City against the euro.
Not at all. There are very different views to mine. You don’t have to look very far from here to hear analysts saying that the euro will fall apart, which I don’t believe. It is important to have your own view without being unduly influence by the views of others.
Would you say that the quality of the information you have been dealing with has been satisfactory in the last ten years?
Yes, I think so. If you mean technical information, I think it’s been generally good.
What about the financial news you get from the usual suspects, Bloomberg, FT, Reuters?
The data service from these sources is usually very good and up to date. Nevertheless, we make our decisions upon the economic research we receive from our brokers, and output from the companies themselves, plus also from official sources like the Spanish government itself, the European Commission, and so on.
I would hope the media does not influence my decisions. Clearly, though, subconsciously, there can be some degree of impact on my perception, but I try hard for my decisions not to be clouded by what newspapers say.
What do you expect will be happening in the euro zone, and what should be happening, in your opinion?
The system was flawed from the beginning— a monetary union without a fiscal union, I think most economists would agree with that, but unfortunately we are where we are and there is little we can do about it—but there is significant political will to ensure that the euro zone remains intact, and that entails an increasing integration amongst the economies now. The issue, and there is no one who knows the answer at this stage, is how the local populations will react to that process.
The reality is that there are cultural and linguistic barriers that prevent free movement of labour in Europe. Furthermore there is clearly resentment in some countries who see themselves subsidising other parts of Europe. I don’t think that is something you’ll find within, say, the US or the UK because they have a broadly similar culture and language within their borders, so it’s not directly comparable to what happens between different countries in Europe.
If the process of integration in Europe is successful, how would that affect the mood in the UK regarding the European Union?
That’s a very difficult question, because there is a very significant part of the British population who are quite Eurosceptic. Now, whether the reasons why they are Eurosceptic are valid or not is open to debate. But, from a UK perspective, an economically strong EU would be extremely helpful, because the UK has significant exports to Europe, so anything that improves the European economy is good for the UK.
I don’t think there are many people who’d want an unsuccessful euro from an economic perspective, but from a political angle, that’s an altogether different matter.