Equity values at levels last seen in the 1970s

In this week’s bulletin:

  • Global markets rally strongly on the ECB’s bond-buying initiative
  • Poor US employment data also fuel hopes of more QE
  • ECB President fires his ‘bazooka’
  • New plan will mean unlimited support for bond markets
  • Spain under pressure to seek assistance
  • European fund manager believes now is the time to increase exposure to financials
  • Equity values at levels last seen in the 1970s
  • Corporate earnings surprising on the upside
  • Poor employment numbers a setback for Obama administration
  • Markets believe US Federal Reserve will announce QE3
  • US economy growing faster than expected as consumer confidence rises

 

Market Eye

  • Global markets rally strongly on the ECB’s bond-buying initiative
  • Poor US employment data also fuel hopes of more QE

Global financial markets were given a huge shot of adrenalin last week as Mario Draghi, President of the European Central Bank (ECB), finally replaced rhetoric with substance by firing his much-awaited ‘bazooka’ in a once-and-for-all attempt to secure the future of the euro. Although some parts of his plan had been leaked in advance, the ECB’s decision to fulfil its role as ‘lender of last resort’ was just what the markets had been waiting for. The euro rallied, and shares – particularly European financial stocks – were propelled northwards as investors welcomed the ECB’s move, notwithstanding some of the gaps in the small print. But it wasn’t just the ECB that galvanised the markets: poor economic data from the US also revived hopes that the US Federal Reserve would have little choice but to embark on another round of quantitative easing, dubbed ‘QE3’ by Wall Street. In response, the price of gold shook off recent apathy, jumping almost 5% on the week as some investors decided to take defensive action. In the UK, economic news was mixed to better-than-expected; which underpinned sentiment that the recession may be ending as recovery resumes once more. In emerging markets, Shanghai finally managed to rally after weeks of decline, with the composite index rising almost 4% on the week.

 

Draghi’s Firepower

  • ECB President fires his ‘bazooka’
  • New plan will mean unlimited support for bond markets
  • Spain under pressure to seek assistance

“There are very many differences with the previous [programme], which lead us to think that it will actually work.”

Mario Draghi, ECB President

After promising the markets he would do “whatever it takes” to save the euro, Mr Draghi finally delivered on the promise by announcing that the ECB was prepared to buy unlimited short-dated government bonds of any country that was in trouble. Mr Draghi believes that, unlike previous attempts to solve the eurozone’s financial crisis, “there are very many differences with the previous [programme], which lead us to think that it will actually work”. This time round, support by the ECB will be unlimited and, crucially, the bank will consider itself ranked equally with other creditors, so its buying will not weaken the credit quality of privately held bonds. The previous attempt involved the restructuring of Greece’s debt and saw international bondholders having to take a 70% loss: this time that will not happen. The markets certainly took Mr Draghi at his word, with bond yields in Spain, Italy and the rest of the periphery plunging, and shares soaring. The reasons for the euphoric response are easy to identify. First, the ECB is promising to take away the risk of a euro break-up, the single largest threat hanging over the world economy: consequently, if you strip that away then every risk asset is worth more. Second was the ECB’s surprise decision to loosen its collateral requirements, meaning it is prepared to accept even junk-rated assets as security against loans. Putting it another way, the central bank is now ready to absorb a large chunk of Europe’s credit and currency risk, making the remaining assets safer.

However, help comes at a price. Support from the ECB for any member state will be tied to reform and austerity measures imposed by Brussels, with the International Monetary Fund (IMF) being asked to supervise errant countries. There is some scepticism in the market as to how the ECB would react if any country being helped missed its targets. If it threatened to stop buying bonds, this would risk domestic turmoil where tougher austerity conditions were imposed as a condition for continued ECB support. The final component of the plan could be a sticking point: the ECB will not intervene unless a country specifically asks for help from Europe’s emergency rescue funds, with all the ramifications of such a request. Spain is under increasing pressure to formally request help over the next few days as eurozone finance ministers battle to ensure the latest package does not fall apart. One ECB source said, “I think everyone would like to see Spain make the request by the end of the week, otherwise there’s a risk the markets will start to get nervous again.”

And of course the politics are complex too. The German government faced a furious backlash from its conservative media and rebel parliamentarians last week in response to the announcement, causing Wolfgang Schauble, its finance minister, to lead a counter-attack against a welter of doom-laden editorials. There is one final point. Even Mr Draghi admitted that whilst his plan would keep the euro together, it would not solve the region’s problems overnight, specifically a lack of growth. Data out last week showed the manufacturing sector contracting for the 13th consecutive month. So while the initial response from the financial markets has been positive, investors will also expect the plan implemented quickly if it is to last and see evidence that growth is resuming.

 

Investing in Europe

  • European fund manager believes now is the time to increase exposure to financials
  • Equity values at levels last seen in the 1970s
  • Corporate earnings surprising on the upside

With the eurozone crisis dominating financial markets for over 18 months, it is easy to understand why investors might have wanted to throw the towel in and walk away from owning European shares. However for investment professionals like Stuart Mitchell of S. W. Mitchell Capital, there are some compelling reasons why owning some of Europe’s top businesses makes sense. “I think it’s important to remember that actually this is not a fiscal crisis. If you look at government debt and their deficits, the figures tell a different story. The eurozone’s debt as a percentage of its GDP is 87%. This compares to 205% in Japan, 98% in the US and 86% in the UK; and the EU’s rise in debt ratio is also significantly less. Consumer spending, whilst growing more slowly in the peripheral states, continues to grow sharply in the North; and German employment is also rising strongly. The banking system is not completely broken and is healing; and one should not underestimate the deep-rooted will amongst the political class for the euro to succeed. I also believe that the central buying of bonds by the ECB would help enormously.

 

 

 

 

 

 

Source: Datastream, MSCI, IBES . May 2012
 
 

 

 

 

 

 

 

Source: GaveKal. 28/8/2012
 

“From an investment perspective the charts tell their own story. The price-earnings ratio [a measure of value] for Europe is sub-10 – in some case as low as 8 – a level not seen since the 1970s, and European companies are trading at a huge discount to their US counterparts: in some cases by as much as 50%. Obviously, weakness in the Spanish and Italian economies is impacting on the likes of Nestlé but I still expect corporate earnings to surprise on the upside in the third and fourth quarters. So what has this meant for my strategy? I have concentrated on quality during the crisis, selling financials about 18 months ago and being more defensive by seeking out companies benefiting from strong growth in the emerging world, particularly those at the top end; for example, Burberry, LVMH and Swatch. However, in the last few weeks I have felt more confident about the outlook and started buying some of what I believe are the better banks such as Banco Santander, BNP Paribas and Intesa Sanpaolo. If the corporate news continues to exceed expectations and the ECB helps then I will add more financials to the portfolio but at present they account for around 15%. The portfolio is aggressively positioned and we are fully invested but I do believe this is the right time to add some more risk: the economic ‘surprise’ indicator has increased with the number of downward earnings revisions for European companies falling, particularly in the financial sector. So, looking ahead, we are pre-positioned for a potentially decent rally in the coming weeks and months.”

 

Mixed Fortunes

  • Poor employment numbers a setback for Obama administration
  • Markets believe US Federal Reserve will announce QE3
  • But US economy growing faster than expected as consumer confidence rises

Away from Europe, investors have been keeping a close eye on events in the US. As the presidential race gathers momentum, both parties are hoping the economic numbers work in their favour. The Republicans are seizing on any bad numbers to use as evidence that Mr Obama’s policies have failed Americans. Conversely of course, the President is looking for better numbers and particularly on the employment front. Historically, no incumbent President has managed to get himself re-elected when the unemployment rate is over 6%; and today that figure is 8.1%. So data released last Friday that showed only 96,000 jobs being created in August was clearly disappointing for Mr Obama’s campaign and, in addition, the data for both June and July were revised downwards. Analysts were expecting 130,000 new jobs and, although the unemployment rated nudged downwards from 8.3%, this was mainly as a result of Americans giving up looking for work and taking themselves off the register. The other piece of unwelcome news came when the Institute for Supply Management’s index for August manufacturing fell to 49.6, the third straight month of weakness. Any number below 50 means contraction but the August number is well above the low-40s level associated with recession.

So what will the numbers mean for future economic policy? Investors believe even more firmly that the US Federal Reserve will have to intervene by announcing another round of QE, perhaps as soon as when the Fed meets on Wednesday. Ben Bernanke, as chairman of the Fed, has a broader mandate than our own Bank of England, with his stated goals being not only to keep the lid on inflation but also to maintain “sustained improvement in labour conditions”. This means the latest employment numbers are as much a problem for him as they are for President Obama. But the situation is not so clear-cut, as the US economy is growing more quickly than anticipated; the OECD is forecasting growth of 2.3% this year as activity accelerates in the second half. On the jobs front, the US has created an average of 150,000 new posts every month for the last two years; which whilst less than the 300,000 needed to bring unemployment down to 6% is still an achievement. Consumers are feeling more confident, which is reflected in a stronger housing market and rising autosales: America’s big three car manufacturers all announced stronger-than-expected figures last week with General Motors’ sales up 10% last month, Ford up 13% and Chrysler up 14%. Despite this, many analysts believe Mr Bernanke will take action. “We think that the Fed will announce QE3 at the next FOMC meeting, along with a change in the forward guidance” was the view of Unicredit. The markets won’t have to wait too long to find out.

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