Europe has been one of our preferred equity regions for some time, and so far, this call has served us well. In the September 2014 Compass, we re-iterated our bullish stance on European risk assets, but since then both the geopolitical and economic backdrop have surprised to the downside.
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The participation of European banks in the European Central Bank’s (ECB) much heralded targeted longer-term refinancing operations (TLTROs) has also fallen short of consensus expectations, increasing uncertainty regarding future monetary actions. So we ask: should we be more cautious on European risk assets?
The story so far
The United States and Europe ex UK have been our preferred equity regions for several years now. Since 2013, the US and Europe ex UK have outperformed other developed regions in common currency terms. (Figure 1) Until the end of May 2014, the performance of our favoured regions had been very similar, with the US and Europe ex UK up 38% and 35%, respectively.1 Since then performance has diverged sharply with the US gaining 4% and Europe ex UK losing 6%.
A 6% depreciation of the euro versus the US dollar since the end of May accounts for part of the Europe ex UK underperformance relative to the US in common currency terms.1 Negative geopolitical and economic surprises in Europe help explain the additional underperformance.
On the geopolitical front, Russia’s aggressive and continued disregard for the law of nations in the conflict in Ukraine culminated in a NATO show of force at a summit in Wales. Further, both the European Union and Russia increased sanctions to a level that will have an economic impact on both sides. It remains to be seen whether Moscow will accept that the government in Kiev still aims for an EU membership and conducts military exercises with NATO.
As we have pointed out many times, fixed income yields across the developed world have fallen, despite a brightening outlook for the global economy, and have caught many market participants off guard. Government bond prices are rising in both the US and Europe, with US government bonds returning 6.5%, compared to 7.9% in US dollar (USD) terms4 for their European Union (EU) counterparts. In the former, yields have fallen less, causing the spread between the two to widen. (Figure 1)The yield spread between European and US government bonds will continue to expand, mainly driven by higher US yields and lower (or stable) EU yields.
Regarding economic news, US data surprised on the upside, while euro zone data missed expectations. (Figure 2) The divergence between news for the US and euro zone has spiked to a level not seen for over one and a half years.
How worrying is the economic news?
Does the latest economic news threaten our outlook on European equities? The basis for our bullish stance on European risk assets is that they will benefit from an increasingly strong global economy. The negative data out of Germany, therefore, is concerning. It is the largest economy of the euro zone, and its economy is export-driven with most of its trade partners located outside the bloc. (Figure 3) The German IFO business expectations index, a leading indicator for German exports, now points towards a contraction in German export growth.2
The good news is that there are other indicators pointing in a different direction. Readings on German output recently rose, remaining firmly in expansionary territory, and offering hope that the principal economic engine on the continent will not slip into recession. Economic indicators outside the euro zone offer additional hope. The ISM manufacturing index in particular points towards an increased level of exports from the euro zone to the US. (Figure 4)
While Germany is well positioned to benefit from global growth, structural issues in the core and peripheral countries are inhibiting their competitiveness. (Figure 5) For this reason, our expectations for the other large euro zone economies are more muted.
France, as the second largest economy, remains in a bleak state, with the influence of entrepreneurs declining and the number of jobseekers increasing. (Figure 6) Hope that the French Government will soon enact meaningful reform should be muted. Popular support for the government is thin and getting thinner, while the political backdrop remains fragile. For Italy, on the other hand, expectations are so low that Prime Minister Matteo Renzi’s non-delivery on his promise to have ‘one reform per month’ has not yet affected his standing. Italy is the country that has the deepest pit to dig out of to become competitive. On the bright side, Spain has made great strides to improve competitiveness, leaving the ongoing autonomy movement in Catalonia as the highest risk for this country.
The depreciating euro: what is the impact on European risk assets?
The recent depreciation of the euro has served as a reminder that a weakening currency makes European equities less attractive for non-euro based investors. Despite this, the case for European equities outperforming on a local currency basis looks compelling: their valuations are attractive, especially when compared to their US counterparts, and their predicted earnings growth is the highest among all developed market regions3. The greater question for investors though is how will they compare with other equities on a common currency basis?
To answer this, we need to assess the medium-term outlook for the euro and the potential impact on equity markets. There is a widespread consensus that the euro will continue to depreciate, but by what amount is unclear. This reflects conflicting views on what drives exchange rates.
Both the one-year real interest rate differential between the euro zone and US, one year from now (“1y1y”), and the one-year forward relative change in the central bank balance sheet size offer reasonable explanations for the EUR/USD move over the last four years. (Figure 7) The longer-term outlook for the euro, however, differs markedly, depending on which driver is more heavily considered.
Projected earnings growth for Europe is the highest among all developed market regions
Those believing that central bank balance sheet sizes are a main driver of exchange rates arrive at the more severe predictions. In this context it is not surprising that our colleagues at the investment bank have placed a caveat on their forecast of the EUR/USD FX rate reaching 1.10 in one year time. They say it is contingent on ECB president Mario Draghi delivering on his plan to expand the central bank’s balance sheet size back to the level seen at the start of 2012.
On the monetary front, the amount that was taken up in the first targeted longer-term refinancing operation (TLTRO) was just €82.6 billion. This figure fell short of consensus expectations and was partly offset by other factors – the ECB balance sheet has yet only increased by about €50 billion.4 (Figure 8) This uninspiring first round of TLTRO raises doubts that the ECB can achieve the planned increase of its balance sheet with the measures made public so far. Some commentators are speculating that as a consequence, the ECB might engage in quantitative easing involving government bonds soon, arguing that it might not formally breach the treaties were the bonds purchased in the secondary market. It remains to be seen what level of resistance such plans would provoke from Germany. The independence of the central bank and its exclusive focus on inflation is of the utmost importance to Germany. Germans might be able to overlook the conflicts of interest that will result from the ECB taking on new banking supervision tasks as part of a single supervisory mechanism (SSM). They will, however, find it hard to believe that the central bank can preserve its political independence once it has government debt on its balance sheets.
By many measures the euro is still expensive, and further depreciation is likely. Our view on the further extent of this decline is, however, muted. We could see the euro falling to 1.20, perhaps even 1.15 in the coming year. Regardless, the depreciation that has already occurred increases our confidence that euro zone equities can deliver on their projected earnings growth, as a lower euro benefits exports. A depreciation of the euro can be beneficial for German/euro zone local currency earnings surprises relative to global equities. (Figure 9) This should lead to an outperformance of euro zone equities relative to other developed market regions, which, in turn, will mitigate or even completely offset the effect of further currency depreciation.
It is likely that the ECB’s actions might fall short of market expectations in the short-term, leading to a gradual pace of decline in the euro. There is a good chance that European equities will outperform other developed market equities on a common currency basis, leaving our bullish stance intact. We will continue to monitor carefully further developments in Europe, particularly in Germany, while acting on the assumption of decent Q3 GDP growth.