In periods when investors become very risk averse, smaller caps are generally derated most, partly due to the lack of liquidity and also due to the fact that swathes of these companies operate in highly economically sensitive areas. The flip side is that this environment habitually offers great value opportunities for investors willing to cherry pick amongst the market fall-out. Indeed, bargain hunters were richly rewarded by rummaging through the stock market wreckage in the autumn of both 2011 and 2012 after fears of a Eurozone meltdown sparked a severe market sell-off.
Eurozone meltdown
It seems we are witnessing a similar meltdown this time round as investors have been clearly spooked by a major growth scare, the possibility of the eurozone entering a recession for the third time since 2008. The International Monetary Fund (IMF) predict there is a 40 per cent chance the region will enter recession and a 30 per cent chance it will slide into deflation. That seems a fair summation of the current predicament the Eurozone faces.
For instance, in the second quarter this year both the economies of Italy and Germany contracted by around 0.2 per cent and France stagnated. Industrial production in Germany fell sharply in August and was way below the weak second quarter level that coincided with the economy contracting in that previous three month period. In turn, this raises the distinct possibility that Europe’s powerhouse may have technically entered a recession in the third quarter.
As the world’s third largest exporter, and the largest economy of the 18 member states, the country is highly exposed to external shocks which largely explain the slowdown its economy has been facing. In fact, in the past few months, trade flows have been hindered by some major headwinds including: the imposition of sanctions on the Russian economy; sharp falls in activity levels of major trading partners including China and Brazil; and a contraction in cross border trade resulting from economic weakness of other member states.
To compound matters the region’s core inflation rate has fallen sharply and at 0.3 per cent is not only well below the European Central Bank’s 2 per cent target, but seems to be heading dangerously close to deflationary territory. Economists and the ECB have been keeping a close eye on the Eurozone’s five year inflation expectations, starting in five years time, otherwise known as the 5-year/5-year forward swap rate. This widely watched rate plummeted below 2 per cent last week, sending out a red alert of a downward lurch in future inflation. For a highly indebted region, this is seriously bad news as it increases the possibility of a recession hit Eurozone entering into a Japanese style debt deflation spiral.
This potential Armageddon scenario has prompted the European Central Bank (ECB) to introduce a new programme of monetary easing by buying up private asset backed securities (ABS) and covered bonds.
The problem is that the monetary stimulus from these measures falls way short of what is needed: full-blown quantitative easing (QE) along the lines of the programmes both the Bank of England and US Federal Reserve have implemented. Indeed, analysts reckon that the ECB will be unable to buy more than €165bn (£129bn) of ABS and covered bonds given the size of these markets, a drop in the ocean compares with the £375bn of gilts the Bank of England bought and the US3,500bn (£2,200bn) expansion of the Federal Reserve’s balance sheet during its three QE programmes. It doesn’t help matters either that the German members on the ECB and the country’s finance minister all vehemently oppose the central bank launching a bond bazooka at the markets. ECB President Mario Draghi may have signalled to the market that he intends deploying €1trillion of funds, but it’s nigh on impossible to see how he can do this with the current measures proposed.
Not even a repeat of the previous long-term refinancing operations (LTRO) to the region’s banks will make inroads. Although the ECB launched another LTRO this summer, the €400bn on offer to European banks in two auctions in June and December only represents €28bn more than the €372bn of existing loans due for repayment from the previous LTRO programmes. In fact, the ECB has seen its own balance sheet contract by a third to €2trillion over the past couple of years as European banks have been repaying €1trillion worth of cheap loans borrowed from the ECB in 2012. Last week it contracted by a further €10bn.
Equity markets
In my opinion, the combination of the end of the US Federal Reserve’s QE programme this month, and a major growth scare from the Eurozone, largely explain the current sell-off in equity markets.
True, it had already been well signalled that the US Federal Reserve would turn off the printing presses at the end of this month, and moves in the bond markets have been pointing to a first rate rise in the US by the middle of next year. However, the degree of the slowdown in the Eurozone has been the curve ball thrown at investors who have been partying for over five years on the back of the liquidity pumped into financial markets from monetary easing.
Given that half of the UK’s trade is with Europe then investors will continue taking cash off the table at least until this growth scare passes. But for that to happen the ECB has no other choice but to launch a full-blown QE bond bazooka and utilise the full extent of its €2trillion balance sheet. It's time for the ECB to act. It's also time for you to create watchlists of shares to buy at bargain prices when the ongoing correction ends.
■ Simon Thompson's book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 and is being sold through no other source. It is priced at £14.99, plus £2.75 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
