Investing in a bifurcated world

The ECB’s dovish approach to the tapering of its QE programme came as a welcome surprise. Mario Draghi made it clear that the central bank will taper only if conditions justify it and that interest rates will be kept at current lows for some time. With the European project entering a new and critical phase in its evolution, Pierre-Henri Flamand examines the market ramifications of this latest policy move and suggests that Draghi’s dovishness may be more meaningful than it initially appeared.

26 JUNE 2018

It feels at the moment as if, notwithstanding globalisation and the interconnectedness of markets, equity investors can only countenance two possible destinations for their money: the U.S. (particularly the Nasdaq) and China. Emerging Markets are being punished from Argentina to Brazil to Turkey, where a mixture of political risk and signs of structural problems in the underlying economies have seen currencies weaken significantly. Europe is suffering both as a result of Donald Trump’s instigation of trade wars (which many had assumed would be merely an empty threat) and the increasingly concerning political situation in Italy. Looking closely at money flows we get a picture of a world bifurcated between winners and losers, with investors less and less willing to risk exposure to problematic situations.

The US stock market currently benefits from strong and persistent earnings growth whereas its fixed income market has been kept in check (despite buoyant economic activity) by the risk of tail events in the rest of the world. U.S. business confidence stands at a 30-year high. The S&P is up 4% YTD with 12-month forward earnings up 14% (according to Bloomberg data) while, in the meantime, the Stoxx 600 is flat with earnings up 5%. This has meant that the US P/E has fallen from 18.2 to 16.7 while Europe is down from 15.3x to 14.3x. The US has, in fact, derated more than Europe, probably as a function of a large part of the earnings upgrade being down to the tax cuts (estimated to account for 2/3rd of the earnings upgrade).

We have written at length before about the FAANG stocks in the U.S. and their apparent ability to outride the issues that are dogging their non-tech peers. The Nasdaq recently hit a new record high, and we believe the flight to tech quality may continue. China is also currently enjoying a historic moment, despite the threat of U.S. protectionism and congressional scrutiny of the relationship between U.S. and Chinese tech companies. The MSCI China Index is on track for its 6th straight quarter of gains, the longest positive run since the index was founded 25 years ago. The IMF recently reaffirmed its 6.6% estimate for China’s 2018 GDP, while strength in commodity markets, robust consumer demand (particularly for luxury goods) and better-than-expected property investment all point to what could be a relatively rosy future for the world’s second-largest economy.

Figure 1. US and China outpace Europe

Source: Bloomberg, 12 June 2018.

There has been an enormous amount of conjecture with regard to Italy, with pundits suggesting any number of possible outcomes in the wake of elections which saw two populist,  eurosceptic parties – Five Star and Lega – assume an uneasy coalition. We haven’t read any analysis that convinces us that anyone has a clear idea which way this will go. Whilst these are certainly worrying times, we wouldn’t leap immediately to the most apocalyptic scenario. One could readily imagine, for instance, Germany being unwilling to open up a new front when they’re already dealing with Trump’s trade wars. There is, after all, a strong argument that the lost decade that Italy has gone through is not just due to a lack of structural reforms but also to a large extent the result of the lack of recapitalisation of the banking system (unlike the situation in Spain).

The important thing to note we believe with regard to Italy is that this is not Greece or Portugal or Ireland. We have become so used to crises erupting in European sovereigns that there’s a temptation to think that Italy is of a similar nature. But Italy is the world’s 8th largest economy and the issuer of the 4th largest stock of sovereign debt in the world. The proposed issuance of mini-BoTs secured upon tax revenues is concerning and, if pursued, could mark a watershed moment for the EU. The treasury bonds could – despite government claims to the contrary – be a clear contravention of the Treaty of Lisbon and a stepping-stone to Italy leaving the single currency.

The apocalyptic scenario some have in mind cannot therefore be assigned a zero probability either. Whatever the outcome, this could be a volatile and unpredictable situation going forward, and has been reflected in a significant gapping out of the Italian risk premium (measured as the spread of Italian government bonds over German bunds).

Figure 2. Italian government bond risk spikes

Source: Bloomberg, 12 June 2018.

Against this backdrop, we awaited the ECB’s 14th June meeting in Riga to discuss the tapering of the European QE programme with no little concern. In the lead up to the summit, European Central Bank chief economist Peter Praet sounded what seemed to be a disturbingly hawkish note, indicating that three tests for the retirement of QE – “convergence”, “confidence” and resilience” – had, in his opinion, been met. In a piece of rhetorical sleight of hand, he suggested that, since there were “waning market expectations of sizable further expansions of our programme,” there was no reason to consider anything but exactly when to finish the stimulus. We’re not sure which markets Praet had been talking to. European banks are down 15% this year, and have underperformed U.S. banks by 17%. The MSCI Europe (ex-UK) has significantly trailed both the MSCI World, Asia and U.S. YTD. It felt like Praet’s comments were paving the way for an aggressive move by the ECB at a time when the European economy feels like it needs all the help it can get.

However, it seems that Mario Draghi either wasn’t listening to his chief economist, or chose to ignore him. Perhaps scarred by the memory of the ECB’s rate rise in the wake of the Bear Stearns bankruptcy – in our view, one of the most ill-judged policy moves in recent years – Draghi left substantial flexibility both in terms of the tapering of asset purchases and, particularly, rate rises. As expected, it was announced that the asset purchase scheme would be tapered from September to December, with total purchases falling from EUR30bn to EUR15bn per month before the programme is due to finish at year-end. It’s important to note the language attached to the announcement, though. Any tapering and termination of the scheme is “subject to incoming data confirming the Governing Council’s medium-term inflation outlook,” so it will only be wound down if economic performance justifies it. Similarly, on rates, the ECB came out with extremely dovish guidance, undertaking to keep rates at current levels “at least through the summer of 2019… and in any case for as long as necessary to ensure that the evolution of inflation remains aligned with the current expectations of a sustained adjustment path.” These are uncertain times for the European economy and Draghi has, wisely, we believe, given the ECB a wide range of possible options should growth or inflation negatively surprise.

UBS recently published a piece of in-depth analysis looking at what impact the withdrawal of QE would have on the European economy. Noting the relatively positive performance of Europe over recent years – the region has seen five years of uninterrupted positive GDP growth – the authors of the article proceeded to show that a larger proportion of this performance can be attributed to ECB stimulus than is widely assumed. Whilst there are positive forces at work within European economies (supply, balance sheet healing, structural policies), we believe these are all significantly outweighed by the impact of QE, which has contributed a cumulative 3 percentage points of GDP output gap closure, and 75bps higher growth p.a. since 2015. Again, in the light of this analysis, the latitude that the ECB has when it comes to managing the roll-off of the asset purchase scheme can, in our view, only be a benefit.

In summary, then, we believe we need to prepare for a potential increasing divide between a reflating US and a Europe that appears significantly less far along the path to recovery. The euro fell significantly in the wake of the ECB announcement, whilst credit assets rallied strongly. In a sustained low-rate environment, European banks could continue to underperform, while high-quality, dividend-paying companies may attract stronger bids. It’s clear, though, that the real market ramifications of the ECB’s decisions will only become clear in the weeks and months to come, when we see whether the performance of the European economy justifies Praet’s optimism or Draghi’s caution.

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