Stronger macro, sink­ing stocks

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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