In fact, the single currency has fallen around 11 per cent in the past six weeks. Further depreciation over the course of this year seems likely too given that the greenback is set to benefit from a normalisation of interest rates in the US at the very same time that the ECB is easing monetary policy, thus widening the yield differentials: 10-year US Treasuries offer a yield of 1.8 per cent, while German 10-year Bunds are priced at 0.36 per cent and those of France and Italy are both at record lows below 1 per cent.
These currency moves should not be underestimated as they will provide a major boost to exports from the Eurozone as euro weakness benefits the corporate sector. Indeed, every 10 per cent depreciation of the euro should increase EPS of European companies by around 10 per cent, so the currency depreciation we have seen already, as investors wisely placed bets on the imminent launch of quantitative easing (QE) by the ECB, is a major positive for the earnings of European companies. It’s also worth noting that the dramatic slump in the oil price in the final quarter last year – down 42 per cent in the period and extending the decline in Brent Crude to around 60 per cent from last summer’s high of $115 a barrel – is tantamount to a multi-billion euro tax cut for European consumers and for companies too by lowering their logistic and input costs.
True, that may not be great news for battling inflation in the Eurozone – the region is clearly in the grips of a deflationary environment which is the very reason why ECB President Mario Draghi has acted so aggressively by launching unsterilized QE – but it’s clearly a positive for corporate earnings. It also explains why European equity markets have rallied hard as investors readjust their earnings growth expectations, a point I previously predicted (‘Europe’s plight worsens.... but that’s good’, 19 December 2014). Indeed, the Eurostoxx 50 index is up 11 per cent since mid-December and the FTSEurofirst 300 is ahead by around 9 per cent.
QE boosts asset prices
This shouldn’t come as too much of a surprise as we have history here: all three of the QE programmes launched in the US by the US Federal Reserve provided a major boost to equity markets. According to analysts at Charles Stanley Stockbrokers the returns on the S&P 500 during these three QE programmes in the six year period between November 2008 and October 2014, when QE3 officially end, were as follows: QE1 (39.5 per cent); QE2 (11.7 per cent); and QE3 (42.6 per cent). The mechanism is simple enough: by forcing investors up the yield curve by reducing the returns on ‘risk-free’ sovereign bonds, this inflates asset prices across a wide range of assets, equities included, as capital is recycled in search of yield. There is little reason to expect this time to be any different given that yields on €1.6 trillion of European corporate and government debt, out of a total of €10.6 trillion in the region, are now in negative territory. And it’s not just investors who will be exploiting the ongoing shrinkage in large corporate and government bond yields.
As Tom Stevenson, investment director of asset management group Fidelity Worldwide, rightly points out the dividend yields offered by 80 per cent of large European companies actually exceed their own bond yields, a rare occurrence indeed. It therefore makes sense for these companies to issue bonds to buy back their own equity as it not only saves net servicing costs for fixed income debt, but in most cases will be earnings accretive too. I would be surprised not to see some major bond issues by European companies in the coming months to take advantage of this pricing anomaly, and one that will be accentuated by the effect of the ECB’s QE programme. It’s only sensible to expect this to stoke the equity rally we are now witnessing.
Financial engineering aside, lower corporate bond yields also act as an incentive for European companies to issue debt for capital investment, safe in the knowledge that they will have a very low hurdle rate to cover the cost on the capital that’s reinvested. In turn, some of this capital will feed down to small and medium sized enterprises given that intra-company loan trade credits account for 40 per cent of the total debt of non-financial companies in the region. Again, this is a positive for European equities. Economists predict that the ECB’s bond buying will boost money supply by around 2 per cent, so it’s only reasonable that some of this cash will boost capital investment. In turn, this will also be positive for GDP. And of course bank lending in the Eurozone is being supported by ultra cheap credit lines from the ECB under the central bank’s long-term refinancing operations. Although banks have been less willing to provide funding to SMEs, any uptick in the economic outlook is likely to provide them with reason to be more aggressive in their lending.
Of course, the naysayers will point out that the MSCI European index is trading on 15 times earnings, hardly a bargain basement valuation. However, this ignores the upside to Eurozone corporate earnings from an increase in GDP and the ongoing fall in the euro (both of which boost exports) and the reduced cost of debt servicing. Bearing this in mind it’s worth flagging up that the Eurozone exports around a fifth of its GDP.
In the circumstances, investors are being very rational in buying European equities and in particular financials and cyclical stocks, the two major beneficiaries of previous QE programmes. They are also being rational in expecting further euro weakness, even though the single currency is becoming very oversold from a technical perspective, so a snap back short-covering rally seems possible in the near-term given the scale of the slide we have seen in the past six weeks. That said, the trend for the rest of this year still looks negative for the euro.
The Greek elections
Of course there are hurdles to overcome to stop investors becoming too complacent, the most obvious being the political situation in Greece following the election of the hard-left Syriza led government. The party have an anti-austerity mandate and leader Alexis Tsipras wants to renegotiate the country’s €240bn bail-out package from the “troika” of the International Monetary Fund (IMF), European Financial Stability Facility and the ECB, accounting for three quarters of Greece’s total debt obligations. But with the ECB back stopping European sovereign bond markets ahead of the Greek vote, and the banking sector far better capitalised than in 2010 and 2011 when the Greek debt crisis was at the risk of spreading contagion across sovereign debt markets, the present threat posed by Syriza to the euro is far more muted. I discussed this subject in detail a few weeks ago (‘A Greek tragedy’, 7 January 2015).
Mr Tsipras will undoubtedly try to play hard ball with the other 18 European leaders, but he has an empty hand as a Grexit from the euro and a default by Greece on its debt obligations would be a financial death sentence for the Greek population. Let’s not forget either that the Greeks don’t actually want to leave the euro; around three quarters want to stay in the single currency and the trend has actually been on the rise lately. All they want is less austerity. That’s hardly a surprise given that youth unemployment is running at over 50 per cent and inflation adjusted national income is still a quarter below the level prior to the start of the global financial crisis in 2008.
Of course, some concessions will be made to Syriza by the troika to enable Mr Tsipras to at least deliver on some of his election promises. The EU has a habit of kicking the can down the road, but I can’t see debt forbearance being on the cards. It’s far more likely that the current debt mountain will be rescheduled to enable easier terms for debt repayments. I certainly wouldn’t be betting on a Grexit at this stage. Analysts at investment bank UBS are of the same mind, forecasting post the Greek elections that there is less than a 10 per cent chance of Greece leaving the euro this year. Equity investors are pretty sanguine about this potential nightmare possibility too with European markets flatlining this morning.
The last point I would make is that the spike in the gold price, largely on the back of the Swiss National Bank’s decision to abandon the Swiss franc:euro peg ahead of last week’s ECB QE announcement, is worth noting. With yields on Swiss government bonds now firmly in negative territory, and those on shorter dated Bunds too, the opportunity cost of holding the one last safe haven is negligible even in a deflationary environment.
The bottom line is that I would not be surprised at all to see the yellow metal, European equities and the greenback (against both sterling and the euro) decisively higher by the end of this year.
Please note that my next column will be published tomorrow at 12pm.
■ 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'
