New Euro­pean cri­sis, same prob­lem

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics By Nick An­drews

Al­most ev­ery year since 2008 has been marked by a “cri­sis” in Europe. Last year’s big headache cen­tered on Grexit, 2014 saw Rus­sia’s land-grab in Ukraine and this year the worry is Brexit and a col­lapse of the Schen­gen open bor­der sys­tem. Euro­pean stocks are down -13% YTD and 10-year bunds yield 0.15%, a de­cline of 48bp. But are th­ese falls jus­ti­fied given that the big­ger con­cern in global mar­kets is cen­tered on emerg­ing economies and a pos­si­ble US re­ces­sion? Af­ter all, the eu­ro­zone rode out the storm last year with un­der­ly­ing eco­nomic growth perk­ing up nicely to 1.5%. Alas, a re­peat per­for­mance will be tough to pull off.

Euro­pean sen­ti­ment in­di­ca­tors have all turned for the worse. Con­sumer con­fi­dence—a fairly re­li­able in­di­ca­tor of turn­ing points in the growth cy­cle—dropped for the se­cond straight month in Jan­uary (see chart). Ger­mans seem es­pe­cially gloomy hav­ing be­come anx­ious about their job prospects in the com­ing 12 months. The lat­est eu­ro­zone PMI showed de­clin­ing new or­ders and more de­fla­tion­ary pres­sure, while the Ger­man IFO in­dex fell to its low­est level since De­cem­ber 2012. Mon­e­tary con­di­tions are also a worry, with the in­fla­tion ad­justed M1 mea­sure turn­ing down de­spite stim­u­lus by the Euro­pean Cen­tral Bank. Taken to­gether, th­ese in­di­ca­tors point to slow­ing growth in the next six months, with firms and house­holds tem­per­ing spend­ing and in­vest­ment de­ci­sions.

Given the weak­en­ing cycli­cal re­cov­ery, we see three main risks:

1) ECB pol­icy and the banks—Eu­ro­zone bank­ing stocks are down -20% YTD on fears that Euro­pean Union bail-in rules threaten in­vestors in mar­kets where non-per­form­ing loan ra­tios are still high. Italy’s bid to ad­dress its bad debt prob­lem has been un­con­vinc­ing and hit in­vestor con­fi­dence. Given the re­treat in in­fla­tion ex­pec­ta­tions and re­duced growth out­look, the ECB is ex­pected to up its mon­e­tary stim­u­lus next month which may mean more deeply neg­a­tive de­posit rates; th­ese hit bank prof­its as many out­stand­ing home loans are linked to euribor which falls when the ECB cuts rates. In Spain most mort­gages are linked with a spread to 12 month euribor, with many of th­ese taken out be­fore 2008 when credit spreads were lower.

2) Refugee cri­sis—The ar­rival of such large num­bers of peo­ple has raised political ten­sions which weigh on con­sumer and busi­ness sen­ti­ment. It is re­sult­ing in some coun­tries rein­tro­duc­ing bor­der con­trols, with EU politi­cians warn­ing that the Schen­gen open bor­der sys­tem could ef­fec­tively end within weeks. Such mea­sures threaten to raise the cost of do­ing busi­ness and re­duce pro­duc­tiv­ity.

3) Pos­si­ble Brexit—Bri­tain’s EU ref­er­en­dum will take place on June 23 and in re­cent days ster­ling has dropped to within a whisker of its 2008 low against the US dol­lar. The cen­trifu­gal forces un­leased by a Bri­tish “out” vote would likely spread across the Chan­nel. And even if the Brits vote to re­main in the EU, the ge­nie may be out of the bot­tle, with other Euro­pean elec­torates in­di­cat­ing a pref­er­ence for a demo­cratic say. In the Nether­lands 53% of vot­ers in­di­cate a de­sire for an in/out EU ref­er­en­dum while the Czech Re­pub­lic’s prime min­is­ter has said that Brexit would en­cour­age de­bate in his coun­try on an EU de­par­ture.

Europe of­fers a dilemma for in­vestors. Since eu­ro­zone bond yields are so low, eq­ui­ties look much more at­trac­tive on a rel­a­tive ba­sis, but given the un­cer­tain­ties out­lined above there is a real risk that the eco­nomic re­cov­ery will now stum­ble. Worse still, mon­e­tary pol­icy seems to have lost its mojo. ECB pres­i­dent Mario Draghi may un­veil a new stim­u­lus on March 10 in­clud­ing in­creased as­set pur­chases, while at the same time at­tempt­ing to as­suage fears on bank prof­itabil­ity. Our worry is that with in­vestor con­fi­dence in mon­e­tary pol­icy as a tool of eco­nomic stim­u­lus on the ebb, the ECB is un­likely to de­liver a last­ing bounce to stocks es­pe­cially given the back­drop of slower global growth. All this leaves long-dated US trea­suries as our pre­ferred as­set.

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