• ECB takes active course to increase balance sheet by one trillion euros.
• European equities are cheap and benefit from an accommodative central ban.
• Eurozone equities have massively underperformed the U.S. market over recent years, but the elements are falling into place for a reversal of fortune.
During times of crisis, investors tend to bring their money home. That the financial crisis started in the U.S. did not deter a repatriation of American investors’ assets. The subsequent Eurozone crisis, with a number of countries on the verge of default, deepened the suspicion about European assets at a time when the U.S. economy was recovering. Hence, it was only natural that when European Central Bank President Mario Draghi made his “whatever it takes” speech in July 2012, many U.S. investors were underexposed to Eurozone markets and consequently missed much of the rally that followed.
As the Eurozone crisis abated, U.S. investors reduced the extent of their underexposure to the region. This worked well during 2013, with healthy returns on equities and peripheral bond markets. 2014 has proved more difficult. The Eurozone economy disappointed and a feeling took hold that the central bank needed to do more. (The ECB balance sheet has been shrinking since 2012, while that of the U.S. Fed has been expanding vigorously.) Equity market returns have been negligible so far this year, though European bond markets have been among the best in the world.
Encouragingly, the ECB is now taking a more active course: Rates paid to banks on their ECB reserves are now negative; the ECB has initiated another long-term funding scheme for banks (TLTRO) and launched asset purchase programs for covered bonds and asset-backed securities. The stated aim is to increase the ECB balance sheet by one trillion euros. As was the case in the U.S., it is hard to believe these actions will provide a direct boost to the economy. (With limited demand for loans, central banks are pushing on a piece of string.) However, if they depress the euro and generate positive wealth effects via financial market strength, that could do the trick.
The bad news is that the take up of the TLTRO program was disappointing. (The banks don’t want the money.) Also, the ECB remains coy about the intended size and timing of its asset purchases. These factors have clearly worried market participants. The good news is that this is expected to spur the ECB to greater efforts -- and that would require government bond purchases. Hence, the ECB could be on the brink of launching the sort of QE program that is believed to have so benefitted U.S. assets.
However, the dark days of mid-2012 are long behind us and valuations suggest investors need to be more selective. With German 10-year yields now below 0.9 percent and Spanish yields below 2.1 percent, it is hard to argue that bond markets are cheap. Even if the ECB becomes a big purchaser of debt, it may struggle to push bond yields much lower, so the best bond returns will continue to be made in peripheral markets. Regional equity valuations are more reasonable -- the Eurozone P/BV is close to 1.5 according to Datastream, which is in line with historical norms. This contrasts with the U.S. equity market where the P/BV is closer to 3 and is well above historical averages.
The comparison with the U.S. can be pushed a little further. Not only are Eurozone equities cheaper, they will also benefit from a more accommodative central bank -- the ECB will ease further, while the Fed has ended its asset purchase program and is likely to start raising interest rates during 2015. Of the two central banks, the ECB will be the more supportive of its financial markets. The counter argument is that the Fed is tightening because the U.S. economy is doing so much better than its Eurozone counterpart. This is true, but a strong economy does not necessarily produce strong profit growth. The U.S. economy is entering the second half of its cycle, during which time profit margins start to suffer under the dual pressure of higher wages and more intense competition (as capital spending rises). The strengthening of the US dollar will be a further hindrance to profits.
Of course, if our minds are turning towards Fed rate hikes, it is only natural to get nervous about global financial markets. However, the hard facts are rather reassuring. During the 16 Fed tightening cycles that we can identify since 1936, in only two have U.S. equities produced negative total returns. Though the data histories are shorter, a similar pattern holds for non-UK European markets since 1971. (Local currency returns were negative in only two of the eight tightening cycles, with average returns virtually identical whether the Fed was tightening or not.)
So, Fed tightening does not necessarily pose a risk to global equity markets. The current stretched valuations in the U.S. suggest a certain vulnerability, but Europe does not have that problem. Over the last five years, Eurozone equities have produced an annualized total return of less than 5 percent (in USD), whereas the U.S. market has produced closer to 16 percent. (Long-term returns in both regions have been in the 9 percent to 10 percent range.) This divergence cannot continue forever, and the elements are falling into place for Eurozone markets to outperform.
Paul Jackson is managing director and head of research at Source, a global investment firm and dedicated exchange-traded fund provider.