As spreads widen, Europe clouds over
You have to go back almost to the darkest days of the euro crisis to see the sort of behaviour displayed by Europe’s bond markets last week. As GDP growth disappointed across the continent (except for in Germany), yields dropped in the US, Germany, France and the UK, but soared in Italy, Spain, Greece, etc. The 20bp or so jump in the yields of Spanish, Italian and Portuguese long bonds in the face of weak economic data begs a question: are we witnessing a reversal in the investment environment for these countries?
Over the past 18 months, European risk assets have outperformed almost all others. As financial theory teaches, the price of an asset is dictated by: a) future earnings streams, b) a discount rate, and c) a risk free rate. Clearly, the big rally in European fixed income was driven by a collapse in the discount rate, followed by a collapse in the risk-free rate. This is why, in any peripheral country you choose, 30-year bonds have far outperformed local equities (see chart overleaf). Last Thursday’s data releases and the market reaction they triggered now pose a couple of difficult questions:
If risk premiums are no longer falling, can rising earnings take over as the main driver of European equity market performance? Some argue for precisely that, pointing to the rebound in small-cap earnings as a likely harbinger of things to come. However, for now, the analyst community seems to be forecasting little, if any, EPS growth for Europe, and it is hardly likely that the latest GDP data will trigger a rush of upward revisions. After all, if domestic GDP growth across most (non Germanic) European countries remains anaemic at best, where will profit growth come from? And if there is no profit growth, why buy into a eurozone MSCI index trading at a P/E of 15x?
Will discount rates/risk premiums continue to fall? Buying unprofitable companies in stagnant eurozone countries that are no longer deeply discounted may make sense if you expect discount rates and risk premiums to continue falling. But this is where the latest action may be important: for the first time in a while, risk premiums on the periphery rose on bad news (instead of falling, as over the past 18 months) - a turn of events that brings us neatly to the quandary the ECB now finds itself in. With bond yields in Ireland, Spain and Italy now trading close to, or below, those in the UK and the US, investors must be reconsidering the attraction of peripheral bonds.
Why own a highly volatile but low-yielding bond currency whose central bank is on record as wishing in a it to weaken? This paradox brings us back to a theme we have explored before: if the ECB acts decisively to weaken the euro, investors may turn their backs on eurozone bonds to avoid exchange rate losses. That would risk a widening of eurozone spreads. If the ECB does nothing, then the euro drifts higher, weakening growth and keeping a bid under eurozone bonds. As we saw last week, the ECB can have a weak euro and wider spreads, or a strong euro and tighter spreads.
But achieving a weak euro along with tighter spreads will prove challenging, unless the ECB pursues quantitative easing far more aggressively than has been mooted so far.
All that brings us to the single most important question raised by the data and the market response: what will the ECB do now? Last week, the ECB promised “action” at its June meeting. The latest GDP releases and the markets’ reaction have raised the stakes considerably. Unless the ECB does “something big” (and that “something big” just got a lot bigger), it will risk severely disappointing the markets.
How many times have our clients seen the ECB do “something big” unless forced to by a crisis? Right-neither have we. As a result, we conclude that the latest events may well signal an about-turn in the investment environment, and that the outlook for eurozone assets has just become a whole lot cloudier.