New European crisis, same problem
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.