In this week’s bulletin:
- Chancellor Merkel will need to push for more eurozone reform and austerity
- The Fed’s decision not to taper its quantitative easing programme surprised markets
- European equities continue to offer good value as business conditions improve
- Markets have undergone a rapid change of sentiment on European equities
The cost of concord
As salvors righted the wreck of a super-sized floating pleasure palace from the Tuscan seabed last week, it brought to mind the eurozone’s own Herculean challenge to haul the region from the financial rocks it hit five years ago. Interestingly, London mayor Boris Johnson in a tub-thumping speech to the Institute of Directors last week also drew on the ingenuity of the international salvage operation to dramatize, for Conservative Party purposes, Britain’s economic renaissance. (There is an irony, probably unintended, that the vessel, when stable and buoyant, will be towed for scrap.) But the image of the US operator Carnival’s cruise ship, the Costa Concordia, twice the size of the Titanic and lying toppled for 20 months in European shallows, has more to suggest, perhaps, about the troubles that have beset the eurozone.
In Germany, there has been a marked silence about the cost of keeping the eurozone together and the euro afloat during the run-up to the federal election and Chancellor Angela Merkel’s resounding victory at the weekend. Merkel and her new coalition government over the coming weeks will need to engage in a renewed round of coaxing and pulling the bailed-out nations of the eurozone periphery towards further public sector reform and fiscal austerity. Merkel’s task so far has been assisted by the European Central Bank (ECB) president Mario Draghi’s promise in July 2012 to do “whatever it takes” to save the eurozone from collapse.
A year ago the eurozone was on the verge of coming apart under the weight of members’ sovereign debt. The perils, including the debt and austerity, remain a year on, but the prospects are looking better for the region – with, for example, Purchasing Managers’ Indices (PMI) picking up early signs of growth across its member states. Rating agency Fitch last week also noted that the intensity of the crisis eased in the first half of 2013 and expects the eurozone to hit a cyclical turning point over this second half of the year. The Olympian efforts of the ECB and Berlin are helping to salvage the eurozone, whether or not it has yet been parbuckled in one piece like the Costa Concordia (or its final destination is a breaker’s yard).
However crucial the victory of Merkel and continuity at the Bundeskanzleramt is for the German economy, the eurozone and Europe’s financial markets, the last days of the federal election campaign were overshadowed by events on the other side of the Atlantic. The US Federal Reserve chairman Ben Bernanke’s decision not to taper the $85 billion-a-month bond-purchase programme surprised markets that had priced in a beginning of the end of quantitative easing (QE). Markets largely expected a reduction of between $10 billion and $15 billion a month. The Fed is not convinced the recovery has reached the “escape velocity” that the Bank of England is also waiting for in the UK. The era of easy money continues with markets looking to the Fed meeting on 18 December rather than 30 October for a decision, and signs of economic improvement in the intervening weeks.
Global equity markets last week reacted positively to the Fed’s announcement, with the S&P 500 index closing on Wednesday at 1,726 points, which was just shy of a record high reached in early August. This followed strong gains earlier in the week on the news of the withdrawal of Lawrence Summers from the running to replace Bernanke when he stands down in January 2014. Monetary policy hawk Summers was also expected to pursue a swift exit from the QE programme. The S&P 500 equity index lost 0.7% on Friday, but was up over the week by 1.3% to rest at 1,710 points with gains particularly from cyclical stocks such as industrials, up 2.7%, materials (2.3%) and consumer discretionary stock (2%).
The Fed’s decision had a positive effect on the major stock exchanges outside the US. In London, the FTSE 100 index gained 0.2% last week, closing on Friday at 6,596 points after a 0.4% fall during the day, with renewed interest in property-related stock after estate agent Foxtons market debut. The pan-European FTSEurofirst 300 index fell back slightly by 0.3% on Friday, although it was up 1% over the five-day period. The German election brought some uncertainty into the bond markets, with the Bund yield over the week down 3 basis points to 1.95% on Friday. The Nikkei 225 Stock Average was up 2.34% over the week to 14,742 points.
Our view remains that tapering relief is a crucial step on the path to normalisation and equity markets need to get used to the oxygen provided at each level of the stimulus, however disruptive this may prove in the short term. Global investors over the coming weeks are also likely to turn their attention to developments in Congress over the US budget and debt ceiling, with a deal needed by mid-October if the US Treasury is not to run out of money. Bernanke’s successor at the Fed also has to be decided, with Janet Yellen thought to be in the lead position. France also presents its 2014 budget, with more austerity measures expected.
The German chancellor gave an impassioned defence of Europe’s currency union in her final campaign appearance before Sunday’s general election. “The stabilisation of the euro isn’t only a good thing for Europe but is of vital interest for Germany,” Merkel told a rally in Berlin. “It safeguards our prosperity and our jobs.” A majority of Germans support monetary union and European unity, but fears linger over the rising cost of the bailout of the troubled eurozone countries – and whether this has put German wealth and prosperity at risk.
Germany faces two critical debates after the election: whether Greece and Portugal – and now Slovenia – will require fresh aid and on what conditions; and whether an authority to shut down failing banks and underpin a European banking union will buttress financial powers in Brussels and away from Berlin. However difficult these questions are for Germany as Merkel starts her third term, the economy strengthened by 0.7% in the second quarter and the 5.3% unemployment rate is a record low since reunification. Investor confidence in Germany is also at its highest since April 2010, with policy think-tank ZEW identifying that Germany’s financial markets believe the economy is gaining momentum.
The eurozone is also clear of its prolonged recession, powered in part by its German engine room, with positive if faint second-quarter growth of 0.3%. France registered 0.5% growth in the same quarter, Greece managed 0.25% and Ireland has also emerged from recession with 0.4% quarterly growth. Meanwhile, September eurozone PMI show further signs of recovery in the third quarter. And the ECB has indicated it will keep market interest rates low to prise further growth from the eurozone.
This renewed confidence is also playing out in the equity markets, with the FTSEurofirst 300 index up 13.5% over the last year and hitting its highest level since mid-2008 last week. The MSCI Europe ex UK index has gained 17% over the last year. Investors have even turned positive on European financials.
Investor confidence in the eurozone, its financial system and businesses has been buffeted heavily since 2009 and the start of its debt crisis. But this view seems to be changing amid evidence of an economic recovery – and a perception that European equities offer good value (in part assisted by the avoidance of the region by many investors). Entry into a market at the bottom rather than the top of an economic cycle is also clearly desirable.
Specialist European fund manager Stuart Mitchell contends that the eurozone is the strongest region in the developed world and will outpace US economic growth next year. However, the founder and investment manager of S. W. Mitchell Capital believes that perceptions of European business conditions that have held back investors are wide of the mark. “In the 25 years I have been managing money for investors, never has the gap between perception and reality on the ground with businesses been so wide,” says Mitchell.
The eurozone offers a range of well-managed and profitable companies with good prospects, says Mitchell. He also believes that European markets are about to begin to enter a multi-year growth phase, following strong returns for European equities in the last 12 months. “The broad market is still trading at a discount to the US of around 40%,” he says. “This has not been seen since the Gulf War in 1990–91, or a small period in the bear market following the ‘tech bubble’ in 2000.”
Mitchell points to the growing market share against US and Asian competitors made by European businesses such as German car giant Volkswagen, chemical group BASF and software conglomerate SAP, as well as France-based aviation manufacturer Airbus. Half of his funds are made up of domestic equities, particularly financials and “restructuring plays”, such as French group Peugeot which has appreciated 90% in the last six months. “There is a stark difference between the consensus that Europe is the sick man of the global economy and the real message on the ground that managers conducting proprietary analysis uncover,” says Mitchell.
Markets and investors in recent months, however, are becoming more bullish about eurozone equities and have been moving into the region amid the emerging market sell-off this summer. Allocations to eurozone equities are at their highest level since May 2007 and investors intend to maintain these flows into Europe, according to a recent survey of global fund managers by Bank of America Merrill Lynch (BofA). In September, 37% of asset allocators surveyed said they were overweight on the eurozone, double the number in August.
What emerges from the BofA global fund manager survey is a snapshot of a rapid change of sentiment on European equities this summer, with more than a quarter looking to be overweight on eurozone businesses over the next year compared with only 2% in July. And it is the growing confidence in Europe’s economy that is underpinning this revival in interest. Half of the fund managers surveyed also believe that stronger EU growth is the key to the region’s debt crisis. BofA’s European investment strategist believes that the eurozone’s economy is robust and equities remain the best value in the developed world despite their strong resurgence.
Fund manager Kenneth Broekaert of Burgundy also identifies Europe as being on the mend. “Our management discussions suggest that business is improving, and it’s partially these expectations that drove European indices up by almost 6% in the last three months and by more than 16% year-to-date [to Sept 13],” says Broekaert. However, he noted that the money that has flowed back into Europe has done so “somewhat indiscriminately”.
Low valuations are driving the appetite for European equities as are the signs of gradual economic recovery that have stirred in the US and UK and are now beginning to appear across the eurozone. Although many investors are favourable about the value on offer from eurozone shares, many are now also waiting to see if there are political and fiscal developments in the eurozone’s periphery following the German election.
Psephologists are probably among the few to enjoy the Byzantine complexity of the German elections, but the odds for a Merkel victory would be hardly worth marking this with a flutter (although Paddy Power earlier this year offered an interesting book for the Vatican’s big day). The thought brings to mind the old City chestnut “sell in May and go away, don’t come back till St Leger Day”. St Leger, of course, is not a European saint, but an 18th-century soldier and horse-breeder who inaugurated the last flat race of the season in Doncaster. The pearl of wisdom suggests one should sell up and enjoy the English summer season, perhaps Ascot, Wimbledon and Henley; and to buy again mid-September ready for leaf fall in the Home Counties and the winter commute.
Researchers at J.P. Morgan have taken time to look into the maxim and found that over the ten summers from 2003 to 2012, the index rose in six and fell in four, so St Leger followers were more likely to miss out on the gains. In 2012, investors would have missed out on a 5% gain – and a 21% increase in 2009 (and there is the matter of doubling up dealing fees and losing dividend payments). That other market adage “time in the market is more rewarding than timing the market” is perhaps a more sage guide. The best of days are often clustered with the worst. Counting when to go out to avoid the latter can come in at the cost of missing the former.