Despite deflation in several countries and concern over the impact of sanctions against Russia, European equity investors have not been put off, lured by the prospect of QE
The poor economic news building in Europe could be good for stockmarkets on the Continent, particularly as the issues creep closer to Germany. Markets have taken a huge bet that the European Central Bank will unleash quantitative easing in the coming months and as trouble builds in the core of the eurozone, this becomes more likely.
In August, French consumer prices fell by 0.3 per cent, meaning the country has joined Portugal in a mire of deflation. The cost of Portuguese goods fell by 0.7 per cent, two-and-a-half times more than expected. Spanish deflation was 0.9 per cent, or 1.5 per cent using the harmonised European measure, with Italian deflation at 0.1 per cent. Poland is also in deflation.
Price growth fell in Germany, too, to 0.8 per cent from 1 per cent in May. While this figure is unlikely to cause much hand-wringing in Germany, other economic news is more troubling. The Zew index of consumer sentiment saw its sharpest fall since 2010 while German exports to the rest of the eurozone had their biggest fall since 2008.
This seems out of whack with the trend in peripheral bond yields this year. The Spanish 10-year traded at one point at its lowest since the French Revolution in 1789 and its yield is now at 2.6 per cent – only marginally higher than the 2.5 per cent for the equivalent gilt.
Italian bonds have continued to increase in price, even as the country’s economic news worsens. Italy fell back into recession in the second quarter, the third time since the crisis began, but its 10-year bonds are trading at 2.7 per cent. This raises the question of how the debt of these highly indebted countries can have become more attractive?
In a deflationary environment it makes sense to accept a lower yield for a long-term bond because this yield will be worth more when paid out as the value of money rises, so this is one explanation for the disparity. But if the market expects deflation, you would more likely see defensive equities doing better than the cyclical parts of the market and equities in general suffering. Neither is the case.
Cyclicals have outperformed this year while markets have done well overall, suggesting something else is going on. The break-evens also suggest inflation is to come, with the spread between 10-year index-linkers and straight bonds 1.17 in Germany, 1.26 in France and 0.9 in Italy.
It is more likely the bond market is pricing in QE in the eurozone. This would explain buoyant equities and low bond yields. QE in the eurozone would keep yields low on government bonds as the ECB steps in to purchase the bonds and drive down yields. Plus, default risk is much lower if debt is being devalued in real terms, as illustrated by low yields in the UK and US over the past few years. This would explain the market accepting a lower yield for Continental debt. And for this to happen as the US and UK are exiting QE and raising rates would give an extra attraction for international investors.
QE has been fantastic for equity investors in the UK over the past five years. The FTSE All Share is up 73 per cent over that time as money has flooded into stocks in search of a yield and in anticipation of ECB action should markets fall. As artificial as it may seem, the prospect of a similar effect in Europe is the major attraction of European equities as the fundamentals show little cause for optimism.
On a valuation basis there is no longer any reason to overweight Europe. The rally in European stocks went further than UK and US stocks last year because it started from a lower base in terms of valuations. This was a major factor behind the 65.19 per cent returns in sterling terms on the Eurostoxx index since June 2012 versus 55.58 per cent for the S&P 500 and 37.05 per cent for the FTSE 100.
Financials, peripheral countries and cyclical sectors all saw huge gains but the P/Es now look unexceptional. The 12-month forward P/E on the Eurostoxx index is 13.74, almost exactly the 13.69 of the FTSE 100. Both look marginally more attractive than the 15.45 times on the S&P 500 but this hardly makes them a screaming buy, particularly when you factor in the economic weakness on display.
German consumer sentiment is low because economic activity is low. The country saw negative growth in Q2 2014 and an alarming drop in exports to the rest of the eurozone. This contraction in GDP was affected by an expansion in construction in Q1 thanks to the mild weather. But Germany’s deterioration is probably what Europe needs to push the ECB towards loose monetary policy, which is the bet that markets have been making.
Germany has always been trenchantly against such a policy but that was when it was doing very well out of the crisis. The markets are betting it will cave in at the last minute and you would be brave to bet against it given the record of European governments.
In any case, political pressures from southern Europe will become irresistible if deflation takes hold. In a deflationary environment, debt burdens grow and interest payments rise in real terms. This would be unbearable for Italy and Portugal, whose respective debts are 133 per cent and 129 per cent of GDP. Something drastic would have to change, whether ECB policy, debt restructuring or Italian membership of the euro.
Recent falls in the equity markets are probably the effect of the tensions in Ukraine hitting sentiment rather than the poor economic data. This suggests volatility in the short term as the crisis rumbles on and perhaps the opportunity for a good entry point and a quick rebound. European equities outperformed UK stocks until the start of July, when tensions mounted in Ukraine and Iraq.
Perception is critical in markets. There is deep concern over the impact of sanctions against Russia on Europe’s economies, despite ambiguous data. German exports to Russia fell at the start of the year but they account for only 3.5 per cent of Germany’s total exports.
Time and again markets have overreacted to the outbreak of military hostilities before rebounding to deliver strong gains to investors who took this as a buying signal.
The volatility could be exacerbated in this case by foreign ownership of European shares. In Germany, 32 per cent of the shares on the DAX stock exchange are held by US investors, according to a study by Deutscher Investor Relations Verband published on Bloomberg. It is difficult to read a foreign country’s politics and you would expect overseas shareowners to jump to alarming conclusions faster than domestic investors. At the end of 2011, non-European investors accounted for 22 per cent of European stockmarkets, according to research by IODS for the European Commission, and the proportion was rising.
We take a neutral view on Europe on a one-year view because the economic recovery remains at an early stage but the prospects are highly dependent on politics. A QE sugar rush is likely, perhaps next year, but this is a dangerous thing to invest in as any boost will probably be short-lived.
In the long term, the currency zone has severe structural weaknesses that will see it lag the UK and US economically and this will be felt in the stockmarket once the recovery phase of this cycle is over.
For European exposure, one of our preferred funds is Henderson European Selected Opportunities, managed by John Bennett. Bennett has a good track record of judging
the business cycle well and of looking past short-term noise in the markets to the long-term themes that are allowing certain companies to outperform. The manager is preparing for a correction in the European market and says the bull run of the last two years in European equities is over.