Posts tagged Euro
This year, the month of March will serve up more than an endless succession of college basketball games and unappealing concoctions of green beer. Almost nine months after the surprise vote last summer, the United Kingdom will finally get to show the world what its exit from the European Union may look like as it triggers Article 50, formally kicking off divorce proceedings. Inquiring investors will want to know how this piece of the puzzle may fit into the evolving economic landscape over the coming years. We take stock of where things stand on the cusp of this new phase of the Brexit proceedings.
Here – Catch This
The UK’s economic performance in the second half of 2016 turned out to be not quite what Remain doomsayers predicted. Real GDP growth for the third quarter – the immediate period after the Brexit vote – was twice what the economists had forecast. With a further strong performance in the last quarter, the UK economy ended 2016 with year-on-year real GDP growth of 2.0 percent, the strongest among the world’s developed economies. Not bad for a would-be basket case!
For most of that time period – from July through November – the main growth driver was consumer spending. For whatever combination of reasons – giddy Leavers on a shopping spree right alongside gloomy Remainers stocking up for the apocalypse, maybe? – households let their consumer freak fly. The pattern changed in the last month of the year. A string of impressive reports from the industrial production corner of the economy in December showed that manufacturers finally appeared to be taking advantage of the sharply weaker pound to sell more stuff, including to key non-EU export markets. That in turn has led to talk of a rebalancing. Consumer spending is unlikely to continue at its recent fervid pace as inflation kicks in and wages fail to keep up – a trend that is already underway. If the services sector can pass the baton onto manufacturing, perhaps the UK could continue to overachieve and make a success of Brexit?
Your Check, Monsieur
The Bank of England has now twice raised its 2017 growth estimate for the UK, so maybe there is some cause for optimism (though it is somewhat hard to see how Britain sustains a competitive advantage as manufacturing powerhouse). A strain of optimism has certainly been coursing through policymaker veins. Prime Minister Theresa May has assured her constituents that the UK side of the negotiating table will push for a most favorable outcome and will fight any EU pushback with nerves of steel. Her government has even hinted at a Plan B should negotiations collapse; a sort of “Singapore on the Thames” financial haven with low tax rates and other incentives for global businesses. But there are a number of potentially thorny roadblocks between here and the promised land.
First off will be an unwelcome bill likely to present itself once the UK team shows up in Brussels. In the eyes of EU budget handlers, British liabilities for things ranging from pension scheme contributions to commitments for future spending projects run to about £60 billion. That is a large chunk of change that (for obvious reasons) has been given short shrift by the UK government in its white papers and other communications with the public on Brexit’s likely cost. EU negotiators give every indication they will insist on the settlement of this account as an up-front divorce payment before any further negotiations on market access, tariff holidays etc. can take place. The British side will be unlikely to go along with that, as it will be in their interests to hammer out a comprehensive solution before they think about a reasonable way to settle accounts. So talks could go off the rails before they even get to the serious issues of economic substance.
What if the negotiations fail? Again, that question has gotten very little focus to date but remains a distinct possibility. An animosity-filled parting of ways between the UK and its largest trading partner (worth about £600 billion per year) would likely not be in anybody’s interest. But each side has its own expectations, its own problems and its own unruly constituents not inclined towards compromise. Bear in mind that, ever mindful of the potential outcome of elections on its own territory, the EU side will be wary of showing any kind of blueprint for easy exit.
And there is a larger picture as well; the Brexit negotiations will be going on during a particularly fraught period for world trade. The Trump administration is hell-bent on scrapping multilateral deals and going after what it imagines to be opportunities for bilateral “wins” (using curiously befuddled and plodding scoring metrics like “surplus-good, deficit-bad”). China would love to lure more scorned partners into its Asian Infrastructure Investment Bank and consolidate supremacy in the Pacific. Brexit, then, will be a big part of an even bigger variable: the rapidly changing face of global trade. However this variable winds up affecting asset markets in 2017, it is likely to have a profound effect on growth and living standards for quite some time to come.
Contrarian investors come in all shapes and sizes, but they all share a variation of this basic way of looking at the world: when the crowd looks one way, it pays to look the other. Today there is an undisputed crowd looking one way -- the Trump reflation-infrastructure trade that shows scant signs of fading, despite a bit of a pause in US equity share gains this week. And there are plenty of good reasons -- we believe -- for looking in other directions, the arguments for which we have set out on these pages in weeks past. But where? This week we consider the merits of one of the least popular asset classes in recent times: European equities.
Europe: The Macro Case
On the face of it, there would seem to be not much to recommend Europe from a top-down analysis of the variables at play. Last year’s Brexit vote hangs over the Continent; while the general consensus remains that Britain’s exit will hurt its own economy more than that of Europe’s, the devil will be in the details of how the parties agree to implement Article 50. Plus, of course, the upcoming elections in France and Germany, and the still-potential wild card of early elections in Italy - will shine a light on the fissures created by anti-establishment sentiment. All this while rattled national leaders and EC technocrats listen for the next approaching Scud missile in the form of a late-night tweet from the other side of the Atlantic.
Valid points, all. On the other hand, the economic health of the region is arguably stronger than it has been since the recession began nearly ten years ago. One of the first macro headlines of note this year was a 1.7 percent reading for consumer price inflation in Germany. Additionally, Eurozone producer prices climbed 1.6 percent year-on-year through the end of December last year. A meaningful part of the jump comes from energy prices; nonetheless, building inflationary pressures would seem to indicate that Europe has moved well and truly back from the deflation trap that seemed all but certain to engulf the region just two years ago. Two cheers, perhaps, for Mario Draghi and his knack for jawboning equity and debt markets.
Moreover, while the upcoming elections could indeed put added stress on the integrity of the common currency region, there is a plausible argument to make against that outcome. Consider the French election, where a victory by far-right populist Marine Le Pen would send shock waves to Brussels. Recently the world learned that the til-now front runner in that race, conservative Francois Fillon, is embroiled in a financial scandal involving fake parliamentary jobs for his wife and children. Apparently nepotism is still a cause for scandal over there - who knew?
The knee-jerk reaction to that news would plausibly be fear that Le Pen, running second in the polls, would vaunt to front-runner status. But wait! The Fillon scandal appears to have worked first and foremost to the benefit of Emmanuel Macron, an independent candidate with a moderate center-left platform who has surged to front-runner status. A Macron win would shake up France’s ossified political system, but arguably in a productive way less likely to be a direct threat to Eurozone integrity. Add to that the likelihood of Angela Merkel winning her fourth term later in the year, and suddenly the Great European Crack-up of 2017 looks less probable.
Europe: the Micro Case
What about the bottom-up view? Well, the obvious place to start would be the valuation gap between US shares and their European counterparts. According to Thomson Reuters Datastream, the twelve month forward P/E multiple for the Euro Stoxx 600, a regional benchmark, is less than 15 times. The forward P/E for the S&P 500, on the other hand, is over 17 times. Now, there have been reasons a-plenty to attach higher valuations to US companies in recent years. Nonetheless, when whole asset classes go out of favor there are usually some very good names that get unfairly tarnished with the macro discount brush.
One area where some contrarians may have been seen fishing about recently is for shares of companies with a significant portion of their revenues derived from outside Europe, particularly in North America or China & Southeast Asia. Remember that for every Procter & Gamble there is a Unilever, for every Exxon Mobil a Royal Dutch Shell. And some of the world’s leading industrial materials concerns -- a sector particularly embraced by the Trump trade crowd -- hail from Europe, among them Germany’s Heidelberg Cement and France’s Lafarge. If you really have to play the infrastructure trade, why not play it with more attractively-valued shares?
The Currency Factor
For a dollar-denominated investor, Europe has been a disappointment for many, many years, and one of the main reasons for that has been the secular bull run of the US dollar. The consensus outlook for the dollar remains strong, mostly due to the imagined outcome of a sequence of interest rate hikes in the US while the Eurozone continues to feed its monetary stimulus program. Every percentage gain by the dollar against the euro is a percentage taken away from the price performance of EU shares in local currency terms. For most of the past eight years, that has been a daunting obstacle.
Again, though, if those EU inflation headlines continue into a trend it is likely to, at the least, put upward pressure on intermediate and long benchmark yields in the Eurozone, which in turn would provide some support to the euro. Back in the US, we continue to see the pace of rate increases by the Fed proceeding gradually and below-trend for some time to come (this squares with our view that the tidal wave of net new infrastructure spending is more a creation of hyperactive investor imaginations than actual likely policy in 2017). With the dollar hovering just a few points above euro parity, there is at least a reasonable case to make that the dollar’s bull run may settle back a bit from its recent pace -- indeed, we saw perhaps a preliminary sign of this with the greenback’s weak January trend.
None of this means that European equities are a fat-pitch obvious source of value. But in a world of expensively priced assets, sometimes it pays to get into the heads of the contrarians and see what they are thinking. We will continue to send reports from this corner of the market as we assess alternative opportunities over the coming weeks and months.
It was almost three years ago to the day. On July 1, 2013, Croatia became the 28th country to join the European Union. “Joyous Croatia Joins Europe Amid a Crisis” ran the New York Times headline of that day. The article noted that the accession of the Balkan republic represented a “rare moment of satisfaction” for an EU beset by stagnant economic growth and a chronic financial crisis. Today there is little in the way of satisfaction or joy in Brussels, as Europeans digest the reality that their club is set to shrink in numbers for the first time since representatives from France, West Germany, Italy, Belgium, the Netherlands and Luxembourg met in a sumptuous room in the French foreign ministry in April 1951 to sign the Treaty of Paris. The British have spoken, and they plan to go it alone.
Of Polls and Pain Trades
Longstanding readers of our weekly commentary will be familiar with our general view on event-driven trades, which is easily boiled down to two simple words of advice: do nothing. The Brexit vote is a compelling case in point for this view. One week ago, poll numbers were showing a slight momentum trend towards “Leave,” risk asset markets were pulling back and volatility was up. Then, a new batch of polls over last weekend suggested that momentum was shifting back towards “Remain,” perhaps in the wake of the brutal shooting of Labor parliamentarian and strong Remain supporter Jo Cox. The momentum shifts in both cases were fairly tempered, with most poll-of-polls composites showing a likely outcome within statistical margins of error either way.
Of course, that did not stop the punters from placing their bets. As the week progressed those bets – now skewed heavily towards a “Remain” outcome, looked more and more like a sure thing. As markets closed for trading on Thursday, the odds as reflected in financial betting markets were over 95 percent for Remain (despite the fact that actual polls still showed nothing remotely that convincing). Global equities closed sharply higher, as did the pound sterling. Then the results came out. There will be pain trades aplenty today, and hopefully a useful reminder about the non-existence of free lunches. Sometimes “do nothing” really is the most prudent course of action.
There is still much that is unknown about the economic impact of Brexit; first and foremost, what specific kind of relationship the UK will have with the Continent going forward. Will Britain be part of a free trade area framework similar to what Norway has with the EU now? Or will there be some kind of customs arrangement for certain goods and/or services, similar to Turkey’s current arrangement? Or something altogether different? There would appear to be plenty of free-lunch thinking among Leave supporters who imagine they can somehow benefit from favorable trade with the EU while restricting the free movement of people (anti-immigration being perhaps the strongest motivating sentiment behind Brexit). Much was promised by the Leave campaign of a highly questionable nature.
That thinking is likely to be disabused by EU negotiators not inclined to be overly accommodating, lest Britain’s example set the stage for further referenda (chatter about France and a “Frexit” lit up the Twitterverse almost instantaneously following last night’s outcome). Article 50 of the Treaty of Lisbon sets forth (very briefly) the terms of disengagement from the union; at this point, all that is clear is that the time frame for leaving is two years. We don’t even know who Britain’s point person in the negotiations will be, as current prime minister David Cameron intends to step down in October. All of which is to say – we would caution against getting too deep into any one particular scenario ahead of even knowing opening gambits on the key issue of ongoing coexistence.
The View from the Corridor
Meanwhile, even today’s frothy market of pain trades and a spike in the VIX volatility index may not drive the S&P 500 below the floor of the corridor where it has been stuck for more than twenty months. So far, at least, the pullback in stocks is relatively contained while bond yields and currencies have also settled down from the more frenetic activity levels seen earlier in Europe, before US markets opened. There is essentially no doubt that central banks the world over are prepared to flood the markets with as much liquidity as they think necessary to stave off a collapse in asset prices (Fed funds futures markets, however improbably, even allow for a 10 percent chance that the FOMC’s next move will be a rate cut). The policy floor is firmly in place. Meanwhile, the next several months may prove even tougher for stocks on the upside, if uncertainty in Europe sets the stage for another strong run by the US dollar. We were just starting to see more corporate management teams gently guide sales and earnings up in expectation of more forgiving currency conditions. Stiffer currency headwinds imply more resistance at the valuation ceiling.
These conditions may change, of course, and we will be closely following the nuts and bolts of how Brexit plays out in the coming weeks. For now, though, we are comfortable with where our portfolios are positioned. We maintained a somewhat more defensive than usual position even as asset markets rallied strongly in March and April, with underweight positions in small caps and non-US stocks while favoring higher quality, dividend-paying large caps. We continue to maintain a modest cash buffer to augment a fixed income allocation of mostly high quality short and intermediate durations. That persistent corridor serves as a useful metaphor in our opinion: neither is it time to go into a super-defensive crouch, nor to let the bulls run rampant. Stay in, but stay cautious.
One week from today we will (probably) know the answer to the Big Question: Are they in or are they out? Britain votes on the future of its relationship with the European Union on June 23, deciding whether it wants to continue to be part of an organization it joined in 1973. While the vote is technically a referendum, not a binding obligation with legal force, a Leave vote would likely require the government to set the wheels in motion for a proposed exit within a two-year time frame. What the terms of any actual deal would look like remains unclear, despite the impression created by much handwringing this week that the economic pain of a Brexit is precisely quantifiable.
Most of the conversations we have had with clients over the past several weeks have, understandably, homed in on the practical implications of Brexit for their portfolios. From our standpoint, the playbook ahead of June 23 is very much in line with our usual advice about event-driven market movements, which is to say do nothing. Make no mistake, if the Leave vote prevails next week there is a very good chance of an immediate volatility spike in asset markets. Much of that volatility would likely be concentrated in ground zero exposures like the FTSE 100 stock index and the British pound, which could see double digit declines, but risk asset markets worldwide would be vulnerable.
The reason we advise our clients to do nothing in situations like this is that, far more often than not, the tempest surrounding the actual event blows over rather quickly. The volatility is driven mostly by short-term money positioned one way or another before the event and algorithms wired to react immediately upon the outcome being known. That flurry of activity will settle down as the winners lock in their gains and the losers bite the bullet on pain trades to cut their losses. Markets will then adjust over time as investors assess the practical implications of Britain outside the EU for the future cash flow generation potential of the companies in which they invest.
Here is one practical example of what we mean by separating the short-term tempest from the longer term market adjustment to new information. Much has been made this week of the spike in volatility for the pound sterling, with commentators noting that the risk spike is higher than anything seen since the 2008 market crash. But an excellent article in Bloomberg carefully points out what other pieces have glossed over: the volatility spike relates only to what traders expect in the next 30 days. In other words, while 30-day futures for the pound sterling are more volatile than those for the Russian rouble or Hungarian forint, one-year sterling futures are virtually unchanged. The market for sterling futures today is a textbook definition of an event tempest: rough seas today, calmness further ahead.
None of this is to say that Britain’s leaving the EU would be unimportant, or have no implications down the line. We are of the opinion that the Leave arguments are largely misguided and shaped more by emotion and fear than by real facts. To that end, our longer-term concern is less about how Britain finds its economic footing outside the EU, and more about how Brexit is part and parcel of a larger global trend – a backlash against trade and globalization in general that seeks refuge in – depending on where in the world one happens to be – appeals to nationalism, authoritarianism and populism. Such sentiments swirl about in locations from Peoria to Paris to the Philippines.
But trying to put a specific price on anything as vague and variable as anti-globalism is a fool’s errand. In a very practical sense we are not prepared to adjust our strategic allocation targets to various asset classes on the basis of events that may or may not transpire. Sometime in the future economic historians may look back at June 2016 as an important milestone towards a new world of less trade and weaker economies. Alternatively, they may write that the populist anger of this age finally forced global elites to wake up and meaningfully address key imbalances and inequalities feeding that anger. Either way, we will follow the same approach as always: evaluate the data as they come in and let the data, not ill-defined emotions, drive our ongoing portfolio decisions.
The punch bowl was not even half empty after Mario Draghi served up another round of stimulus last week, but Janet Yellen & Co. filled it right back to the brim on Wednesday and the party rolled on. The surprisingly dovish statement after this week’s FOMC meeting acknowledged what credit markets had already priced in: the cadence of rate hikes is going to be much gentler than December’s “dot plots” suggested. The brisk central bank tailwinds of late, along with a general absence of anything truly bad having happened for some time, have pushed the S&P 500 through some key resistance points. The index now finds itself…right back in the corridor where it has been for much of the past 15 months. The question for investors now is what it will take to push stocks through the corridor’s ceiling. We believe a sustained second leg of this rally will be considerably more difficult than the first.
Relief Rallies of a Feather
The two conspicuous banishments from the corridor share some characteristic patterns of intermittent bull market corrections: an initial steep drop followed by a sequence of tentative rallies and selling waves, and finally a double-digit relief rally to reclaim the lost ground. The chart above shows that the market finally kicked into gear in October 2015, rallying 13 percent back to the middle of the trading corridor. Similarly, shares recently have pushed up nearly 12 percent from their February 11 low point. The recovery has been fairly broad, as noted in some of our recent commentaries. Market breadth indicators like the advance-decline and 52 week high/low ratios are reasonably healthy. Higher risk areas like small caps and emerging markets are going gangbusters; to cite one example, Brazil’s Bovespa index is up 35 percent since its late January lows. That’s a bit surprising given that the economy is mired in a deep recession and the country’s political system is falling apart. Animal spirits and all that.
Given those animal spirits (and the auto-refilling central bank punch bowl), it is not hard to imagine that there is a bit more near-term upside for U.S. large caps. The S&P 500 is about 4.4 percent away from the all-time high it reached 301 days ago. Can it get there? Anything is possible, of course, but we imagine the headwinds are going to start getting stiffer if shares manage to get back to the middle of that corridor. That is when investors will have to start asking themselves whether this bull market still has room for another burst of the valuation multiple expansion we saw in 2013 and 2014.
The Valuation Ceiling
In 2013 stock prices soared, while earnings moved ahead at a more leisurely pace. Earnings per share on the S&P 500 advanced 5.6 percent that year, while share prices topped 30 percent for their giddiest year since 1996. Prices kept going up in 2014 and the first half of 2015, while earnings gradually tapered off and eventually turned negative. The chart below shows the 10 year trend for the next twelve months (NTM) price to earnings (P/E) and price to sales (P/S) ratios for the S&P 500.
Both the P/E and the P/S ratios remain considerably above their 10 year averages. Even at the low point of the recent correction the P/E ratio was only briefly below its pre-crisis 2007 high, while the P/S ratio didn’t even come close to approaching its 2007 levels. Now let us consider the outlook for the rest of this year. The most recent consensus outlook for Q1 2016 earnings per share according to FactSet is -7.9 percent, while the EPS outlook for the full year is 3.2 percent. Sales are expected to be slightly negative in Q1 and to grow by about 1.5 percent for the year. Now, it is plausible that sales could enjoy a light tailwind if the dollar continues to weaken in response to a more dovish Fed. And some recent price and wage data suggest at least the possibility of a brisker than expected pickup in consumer activity in the U.S. (though this data was largely downplayed by the Fed this week).
Even so, though, we see little to suggest that the cadence of EPS and sales growth will be strong enough to lift prices too far off their current levels without pushing the valuation metrics closer to bubble territory. For that to happen, we think we would need to see some random confluence of events acting as a catalyst for a melt-up. That’s not out of the question – melt-ups have served as the codas for previous multi-year bull markets. But predicting the timing of such a melt-up is a fool’s errand. Meanwhile, that valuation ceiling looks fairly imposing.