Stronger macro, sinking stocks
The latest macro indicators leave little doubt about the general direction of the eurozone economy. Both hard and soft data suggest that growth re-accelerated from a meagre 0.3% QoQ (1.2% annualised) in 3Q15, probably to 0.4%-0.5% (1.6%-2.0% annualized) at the turn of the year. Eurozone unemployment declined to a four-year low in December, and the economic sentiment indicator compiled by the European Commission from business and consumer surveys rose to its highest point since mid-2011. The German export sector has so far proved relatively resistant to slower growth in the emerging markets and to the Volkswagen shock, while domestic growth in Southern Europe continues to improve on the back of the European Central Bank’s quantitative easing, cheap oil, and less restrictive fiscal policies.
Moreover, while investors have good reasons to be concerned about the impact of falling oil and commodity prices on US and EM debt markets, they seem to be ignoring the positive impact that cheaper energy and resources will have on financial risks in Europe, especially in Southern Europe. Thanks to lower commodity prices, Italy and Spain can spend more without a deterioration in their current account balances. Even with growth of more than 3% in consumer demand, Spain is likely to maintain a comfortable current account surplus of almost 2% of GDP. Similarly, it is now almost certain that Italy will keep its net lending position of 2.5% of GDP intact, even while its domestic economy accelerates substantially.
By continuing to support economic growth in Southern Europe, cheaper oil also helps to reduce the financial risk posed by non-performing loans. This is especially important for Italy, where EUR 350 bln of NPLs (18% of total loans) are a sword of Damocles over the banking sector. With lower unemployment, lower interest rates and higher incomes, one can be confident that this number will soon begin to decline, as it now has done in Spain for two consecutive years.
As a result, it is surprising that Europe’s equity markets have not performed better in relative terms. Since early December, European indexes have declined by -10% to -15%, while the S&P 500 has lost -8.6%. One theory is that where markets lead, the economy follows. This is hard to believe, since last summer’s market tantrum failed to foreshadow any significant weakening in Europe’s economy. Another is that heightened political risk—uncertainty in Spain and Portugal, talk of Brexit, fear of terrorism and the refugee crisis—is to blame. This is not convincing either, since sovereign yield spreads have barely widened.
As in 1997-1998, when European markets saw huge volatility against a backdrop of solid economic recovery, the most convincing explanations are beta and composition. The beta of European equities relative to US equities has almost always risen above one at times of heightened perceived global risk. This reflects a lack of confidence in the capacity of the European economy to resist external shocks, and in the ability of European policymakers to react effectively to those shocks. In this respect, the ECB disappointment of last month cannot have helped.
The other reason—equity market composition— reinforces the beta effect. The most liquid and utilised equity indexes, such as the Euro Stoxx 50, the Dax or the CAC (not to mention the FTSE 100), are heavily overweight in big multinationals exposed to EMs and commodities. This effect has been very pronounced in recent months, as shown by the sharp divergence in performance between small and large capitalisation stocks, and by the sustained outperformance of our pan-European equity group.
The divergence in performance between those European assets that are most sensitive to global risks and more regional assets is likely to remain pronounced. The risk exists, however, that even the latter defensive stocks could eventually become contaminated by the fear factor. This risk requires a hedge. Thus I reiterate my early December call: maintain exposure to equities exposed to Europe’s domestic demand, and buy 30-year US treasuries as a hedge until the perception of global risks calms down.