Portugal Is Set To Grow

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Includes: PGAL
by: Paulo Santos

Summary

There are two strong factors which will drive Portuguese economic growth in the next 2 years.

One of these factors has already been at work for a while.

The other is new and just about to make its impact felt. This second factor is historically very powerful.

I'm writing this article because a particular set of circumstances has materialized that greatly favor Portugal's growth over the next couple of years. One of the factors I'll describe has been working for a few years already, but the other is totally new. Here we go…

Tourism

Besides an economic turnaround in many source markets, there's been a factor that greatly favors the Portuguese tourism industry.

I am talking about Muslim radicalism. Muslim radicalism is basically destroying tourism in many countries. People have this irrational fear of being shot at or beheaded, so they're leaving prior tourist destinations in North Africa and the Middle East.

Take, for instance, Egypt. Egypt was previously a large and growing tourist destination. This is how it's been performing as of late:

Source: TradingEconomics.com; Egypt; Tourist arrivals

Even Turkey, a more moderate Islamic country and also a large and popular tourist destination, is showing the same troubles (there also helped by the 2016 purge):

Source: TradingEconomics.com; Turkey; Tourist arrivals

Even outside of majority-Muslim countries, Islamism is having an impact. For instance, France - on account of recurring Islamic terrorist attacks - has been rather stagnant:

Source: TradingEconomics.com; France; Tourist arrivals

Portugal, on the other hand, has been on the side which benefits from all of this turmoil:

Source: TradingEconomics.com; Portugal; Tourist arrivals

Tourism, being such a large component of Portugal's economy (travel and tourism exports account for ~6.9% of GDP and 6.4% of employment) ends up having a large economic impact. Especially as it expands quickly due to this catalyst.

Tourism, of course, has been expanding for a few years already, so it's not as novel as the next factor.

Residential Construction

First of all, Portugal is a weird place to have a real estate bubble right now. Portugal's population is actually decreasing, mostly on account of emigration.

Source: TradingEconomics.com; Portugal; Population

However, real estate prices have recently been booming. Indeed, at present, they've already exceeded the highs of the previous real estate bubble - though this is yet to be reflected entirely in housing price indexes.

Source: TradingEconomics.com; Portugal; Housing Price Index

This renewal of the real estate bubble has happened mostly on two counts - one objective, one subjective:

  • The objective part is that presently financing the purchase of a house is the cheapest it's ever been. Nearly all real estate debt in Portugal uses variable interest rates plus a spread. During the previous real estate bubble, spreads got as low as 0.50%, but interest rates still stood in positive territory (2-5%). Right now, spreads are a bit higher at 1.2-1.5% since credit is tighter. However, for a real estate borrower, the effective interest rate right now is, even assuming EURIBOR at 0% (it actually stands at around minus 0.30%), 1.2-1.5% versus 2.5-5.5% during the past bubble. Thus, for the same house price, it's cheaper to buy it now. Hence, prices are easily going above the past bubble peak.
  • The subjective part is that demand is concentrating on modern housing. While there is a large excess of housing stock available for purchase, that housing stock mostly looks like something Lenin himself designed. As a result, for many potential customers, modern housing stock is the only thing that actually "exists." Of course, since the previous bubble construction ground to a halt, so no more modern housing stock was built. So now, there isn't enough to go around. There's scarcity even in the middle of an oversupplied market.

Examples of old housing stock

Examples of new housing stock

To this, we could also add a factor that's creating demand even for old stock within central locations: Airbnb (AIRB).

While this dynamic has been ongoing for a while in terms of prices, its economic impact will only now start being felt. Why? Because such economic impact comes essentially from construction accelerating. And as of 2015, construction was still on the doldrums, but we could already see licenses inching up:

Source: INE - the Portuguese Statistics Office; Blue line is the variation of licensing for new residential construction

That (residential) construction is set to accelerate strongly is a certainty. While today's real estate prices are higher than the top of the last bubble, today's construction costs - whether for labor or materials - are lower. This means that for construction companies building today, there's the prospect of extreme and immediate profits. In capitalism, such opportunities are not left on the table. Indeed, if anything, they're taken until it's idiotic to do so and it leads to massive losses. We're far from that right now, though, so right now, what we will see is very rapid construction expansion.

Construction, for its part, is an extremely intensive economic activity, drawing a massive number of inputs from materials, to labor, to fittings, ultimately to all those furnishings that go into a new home. This will have a far-reaching economic impact and should be enough, by itself, to propel economic growth of the entire economy over the next couple of years - on top of the tourism impact.

This development will also hit far and wide. Take banks, sitting on mountains of real estate defaulted debt, both from consumers and from real estate companies. These defaults will rapidly drop. The otherwise-shrinking loan books will regain growth. The recoveries on defaulted debt will improve. A virtuous cycle will hit here and elsewhere in the economy - as jobs are created, purchasing power increases, for real estate and for everything else.

What's underpinning all of this? Basically, the ECB with 0% interest rates and massive ongoing QE. QE is set to end during 2018, but interest rates won't rise until then as well. And even if they were a bit higher, as I've said, the current interest costs are significantly below those attained during the last real estate bubble. Plus prices could fall some before hitting construction activity, since the margins at this point in the cycle will be so large. As a result, this dynamic might well have 2 years to run.

Conclusion

On account of tourism and especially on account of real estate, Portugal's economy has a couple of years of easy sailing in it. This is bound to generate investment opportunities. I must say I don't particularly like most Portuguese companies, though. EDP (OTCPK:EDPFY) is over-leveraged. NOS is seeing massive competition. Pharol (OTCPK:PTGCY) is Phu… I mean, you get the point. Still, Portugal as a whole will be doing well in the next couple of years. I'd expect Sonae and others to benefit, for instance. The overall market should also benefit.

On a market-wide basis, Global X MSCI Portugal ETF (NYSEARCA:PGAL) is the only ETF I could find right now.