Premier’s Jake Robbins: The diametrically different paths to profit for Europe and the US

Robbins Jake Premier Asset Management 2014

It appears we are now entering a period when the Fed is tightening monetary policy at the same time that the ECB is heading towards full blown quantitative easing.

So ends the longest period of coordinated global monetary easing in history. The question for investors therefore is what implications does this have for markets, and how do I profit from this environment?

The likelihood of a US rate hike has clearly begun to be taken more seriously in the currency markets.

Up until now the Euro has defied gravity against the dollar, refusing to weaken despite sharply differing economic fundamentals. A clear commitment to continue to cut rates, even into negative territory, and start the process towards QE has finally seen the Euro capitulate.

Likewise, the US dollar, after a period of perplexing weakness, has now risen substantially against all major currencies as persistently strong economic data indicates that a rate rise must soon follow the end of quantitative easing in November. An early 2015 rise is now very likely.

This compares to Europe where two-year yields are currently negative in at least nine countries, with investors even willing to pay Ireland to hold onto their money which seems extraordinary given they were utterly shut out of bond markets until recently.

Congratulations to Mario Draghi for reassuring bond markets to such an extent that the ECB will stand behind all eurozone sovereign debt despite not really having the authority to do so.

With such starkly divergent monetary conditions, how should one be positioned?

Loose monetary policy is generally associated with strong equity markets. Lower rates make the cost of investing cheaper and tends to boost valuations and thus markets rise. Also lower rates are expected to boost economic growth and stimulate company sales and earnings, further supporting equities as investors buy in anticipation of this upturn.

In the Eurozone of 2014, however, things may go much differently. With rates effectively at zero, deflation an ever-looming threat and economic growth more likely to slip into recession than strongly recover, then markets may find it harder to advance meaningfully on the back of monetary stimulus.

Throw in valuations that are towards the top end of their historic range, then, without a significant upturn in economic growth, it is again hard to see markets make much progress.

The stand-out investment strategy in Europe, however, remains yield investing.

The Stoxx Europe 600 is currently yielding around 3.6 per cent, far ahead of any 10-year sovereign bond outside of places such as Greece and Russia.

There are plenty of steady businesses paying big dividends that are easily generating sufficient cash flows to cover 4 per cent, 5 per cent or even in excess of 6 per cent dividends that surely make better investments than the extremely expensive bond markets.

Those companies that are paying high dividends, well covered by cash flows – even in a weak economic environment – will likely be sound investments for some time to come as the European economy continues to stagnate.

Incidentally, the other type of investment that is usually expected to do well in response to monetary stimulus is the financial sector, mainly the banks.

However, this time round I would be extremely careful in this sector.

Banks remain over-leveraged and have yet to fully own up to their reckless lending habits pre-crisis. Banks are ultimately highly geared cyclicals in a very weak economic environment. Unless you are very optimistic over the European economy recovering strongly, this continues to be a sector best avoided as a value trap.

In the US, on the other hand, you have tightening monetary policy and a high likelihood of rising interest rates. For the same reason falling rates is good, rising rates have traditionally been bad for markets. Higher rates make investing more expensive and depress multiples and tend to slow economic growth which is bad for future earnings prospects.

Again though, to put this into context, rates are rising from having been near zero for almost six years. The US economy grew 4.2 per cent annualised last quarter. Unemployment has tumbled and industrial production and consumer spending are recovering strongly.

In this context the markets should welcome slightly higher rates as a sign of economic health and not as something to be feared as a tool to slow growth.

Cyclicals in the US should do well. So should banks, as rising rates tend to push up the net interest margins they can achieve from lending and borrowing.

Embrace the recovery in the US by buying industrials, financials and consumer discretionary stocks, and avoiding the very same higher yielding investments that will likely work well in Europe.

So two very divergent central banks and investing environments, but there is money to be made in both markets.

There is plenty of commentary currently encouraging investors to dive into European cyclical recovery plays on the back of the ECB stimulus. However, valuations and the current environment would suggest that that is a bad idea. Stick to the more prosaic yield plays and look to the US for the real recovery opportunities.

Jake Robbins is manager of the Premier Global Alpha Growth Fund