Weekly Market Commentary - Europe's Big Bet
The ECB made a big bet last week that the Eurozone economy is picking up fast enough to avoid the need for any further stimulus. We are not so sure. Until some key catalysts emerge, the risks to stocks in Europe may outweigh the rewards.
Europe's Big Bet
Bond yields have fallen this year, but they began to rebound in the United States in the latest week as the glass-half-empty bond market realized the all-time high stock market may have it right. But this was not the case in most of Europe. The ongoing decline in European government bond yields continued last week and is striking when considering how fast they were rising two years ago. What a difference a couple of years can make. The 10-year Italian and Spanish bond yields dropped to near all-time lows at the end of last week, while Greece’s 10-year — once over 35% — fell below 7% [Figure 1]. Problem solved? Not exactly.
The countries once derided in the financial press for overspending PIIGS (Portugal, Italy, Ireland, Greece, and Spain) and thought deserving of their double-digit borrowing rates, could now be believed to be among the GAUDS (Germany, Austria, United Kingdom, Denmark, and Switzerland) and their low single-digit yields. As we have highlighted several times over the past two years, bond yields have receded as the risk of financial crisis has passed. But the situation in Europe is slowly transforming into an economic crisis in the form of a potential lengthy stagnation. We had anticipated Europe could shake off this risk and produce better growth this year — and it still may — but the risk of a setback rose last week.
The risk can best be seen in prices. Central bankers around the world, including the U.S. Federal Reserve (Fed), the European Central Bank (ECB), and the Bank of Japan (BOJ), have a clearly stated goal of 2% inflation, to motivate spending and lift wages while leaving a buffer above zero when growth inevitably slows again. While the inflation rates in the United States and Japan are just below that and rising, the pace of inflation in the Eurozone has been under 1% since October 2013 and is still decelerating.
Last week, rather than making a move at its meeting to cut rates or take other actions, the ECB took a gamble that the economic momentum in the Eurozone may be self-sustaining enough to turn prices higher on its own. The status quo announcement was accompanied by the release of the ECB’s forecast for inflation in the coming years, showing it expects inflation to remain below 2% through 2016. Not only has the ECB refrained from any new stimulus, it has been outright shrinking the bonds on its balance sheet for over a year now, in contrast to the Fed, which is just starting to slow the growth in the bonds on its balance sheet by tapering its pace of bond buying [Figure 2].
The problem for Europe is an elevated risk of economic stagnation, a rise in the value of the euro hurting exports, and very low rates of inflation making it very hard for countries to address their debt and pension problems. Despite years of austerity in the form of tax hikes and spending cuts, Eurozone government debt-to-GDP (gross domestic product) has risen to a record 93%, up 4% from a year ago, according to Eurostat, the official statistics office of the European Union (EU). Higher inflation is necessary for the Eurozone to avoid what Japan has experienced — a high debt and pension burden coupled with flat inflation and economic growth for much of the past two decades.
We remain hopeful that in 2014 Europe can overcome its weaknesses and have a better chance for returns competitive with U.S. markets than last year. Here are the catalysts we are looking for to turn more positive on European stocks:
* Lower expectations for earnings growth – The current earningsexpectations are likely to be disappointed. The consensus of analysts’ estimates for European company earnings are for 12.2% growth in 2014. This seems high given prospects for only about 1% GDP growth, especially
compared with the consensus for the United States, which now aligns with our outlook for 8.8% earnings per share growth for the S&P 500.
* Lower valuations – Although European stocks usually trade at a discount to U.S. stocks due to a different sector mix and slower growth, at a forward price-to-earnings (PE) ratio of 13.3, compared to 15.8 for the S&P 500 Index, the discount is not sufficiently pricing in the greater risk of economic stagnation.
* Inflation picking up back above 1% and rising – A key sign that the risk of deflation is receding.
* ECB action – If the euro moved toward $1.45 or longer-term inflation expectations fell, it may prompt a move by the ECB to reduce the risk of stagnation, which markets would welcome.
* Loan demand picking up – Signs that business loans are increasing, rather than the declines indicated in the surveys, would be a welcomed sign that the bridge is being made between recapitalizing the banks and getting them lending again.
Despite inflation being in the ECB’s “danger zone” and rising debt burdens, the ECB made a bet last week that the Eurozone economy is picking up ast enough to avoid the need for any further stimulus. We are not so sure. Until some of the above catalysts emerge, the risks to stocks in Europe may outweigh the rewards.