Europe is likely to scrape along with anemic growth for at least the next decade. I do not love the outlook from a geopolitical or demographic standpoint. Second order effects from Brexit will likely last for years. Monetary and fiscal policy is almost broken. Negative interest rates are toxic for the aging population of savers. But there are some great dividend payers in Europe and because of the rather poor outlook, the market is not expensive such as the U.S. market. The most recent hurdle for Europe's ailing banks is the European Central Bank's stress tests.
As part of their mandates, financial system regulators conduct frequent reviews of their members. Last week, the European Central Bank released the results of their 2016 bank stress tests. A few weeks back I noted that Italian banks are saddled with €360-billion in non-performing loans (NPL); this is about 20 per cent of GDP. As a comparison, NPL in the United States is about 1.2 per cent of GDP.
Italy is particularly vulnerable because the banking sector is a recession away from a collapse that would make Greece's debt problems look like a rounding error.
Italian Prime Minister Matteo Renzi is holding a referendum to change the way the election process works (not unlike what the Liberals have proposed in Canada without a referendum). If he loses, Mr. Renzi has promised to follow former British prime minister David Cameron's lead, and quit.
A July 1 public opinion poll by Euromedia Research said that 34 per cent of Italians would vote against Mr. Renzi's plan, with 28.9 per cent in favour, 19.4 per cent undecided on which way to vote and 17.7 per cent undecided on whether to vote – so that means anything can happen. The Italian anti-EU Five Star Movement Party is gaining popularity and is likely to win an early 2017 election and have already promised they would hold a Uscita (the Italian word for exit) referendum.
The accompanying chart shows the Italian bank index versus the Pan-Europe bank index in percentage terms.
As you can see, it is not just Italian banks that are the problem, the entire European bank index is significantly stressed – down some 80 per cent in the past decade with more than 50 per cent of banks below the lows seen at crisis lows in 2009. It is very difficult to grow your economy when the banking sector is not performing well – just ask the Japanese. This is one of the major reasons why Europe has lagged global markets in recent years.
In 2012, when Mario Draghi, the European Central Bank chief, said he was all in and would do everything he could to stimulate growth the euro weakened and we saw banks double from their 2012 lows.
But from March, 2015, when they actually started quantitative easing and then moved to negative rates, banks have tanked and so, too, has economic performance.
The bottom line is that every cycle needs a cleansing of bad debt and we simply have not had it.
There is more than 50 per cent more debt in the world today then there was before the 2008 financial crisis. More borrowing and spending stimulus will not likely work, and all the debt in the world is a massive headwind to growth.
As long as the governments of the world continue to pile on debt to stimulate their economies, interest rates will remain low, and global growth will likely continue to slow. The odds of a credit crisis in Europe or China over the next few years is extremely high. The European banking index is telling us not to trust the post-Brexit rally in equities. (Don't even get us started on the trouble with bad bank loans and shadow banking in China.)
The ETF I like most for investing in high dividend paying European equities is the BMO Europe High Dividend Covered Call Hedged to Canadian Dollar (ZWE-TSX). It holds 30 high-dividend-paying, high-quality European stocks diversified across all economic sectors. Currently, it holds 20 per cent financials, of which two are higher-quality banks (HSBC, Nordea) and three insurance companies (Allianz, Swiss Re, Zurich) – largely avoiding the troubled southern region of Europe. The expected yield is about 7 per cent from a combination of dividend and covered call premium. In a world starved for yield, this is a good holding that will help diversify out of the expensive U.S. market.
You just read 7 per cent, so before you stop reading and race to buy it please take note that it's not without risk – you are buying equities.
The historical volatility is about the same as the world equity market and should not be considered as a fixed-income replacement.
The currency hedge means that you don't have to worry about a weaker euro should more countries line up to leave the common currency, which I expect will happen over the next several years. There is likely more stress to come. I own this ETF in the BMO Tactical Global Growth ETF fund and also the BMO Tactical Dividend ETF fund (aka the "sleep-at-night portfolios"), both of which I manage.
Larry Berman