This huge money printing programme has not just led to a sharp contraction in government bond yields across the eurozone, but also a sharp depreciation of the euro. That's basic economics, because if you increase the supply of an asset then buyers will simply demand a better price to compensate. The currency markets are no different, a point I made at the end of last year when I forecast the implications for a host of markets in the likely event of the ECB turning on the printing presses ('Fireworks to set markets alight', 19 Dec 2014).
In fact, the single currency has fallen by over 8 per cent against the US dollar and by 8 per cent against sterling since the start of this year. Clearly, this is good for the competitiveness of the eurozone, which has been battling to stave off the twin effects of a recessionary environment across the southern Med block and the threat of the most indebted countries falling into a debt deflation spiral.
And there can be no doubt that the ECB's bond bazooka has been successful in driving down sovereign bond yields, as highlighted by the record low yields hit in recent months for German, Italian and French government debt. In fact, the yield contraction undoubtedly went too far as at one point last month prices of 10-year German bunds had surged to such an extent that their yields were only five basis points, prompting the highly respected bond guru Bill Gross of Janus Capital to label them the "short of a lifetime". He had a point - as instead of taking on risk for yield, this was in effect taking on risk for no yield given the pitiful returns embedded in the price.
In this zero interest rate environment investors have been forced up the yield curve to boost their investment returns. This helps explains the positive wealth effect in European equity markets this year as capital is redeployed into higher-risk assets, and ones that will benefit from the improved growth expectations in the eurozone, much as I outlined in my analysis in that December article.
That's only rational behaviour as it's reasonable to expect a lagged boost to corporate earnings from the depreciation of the euro and improved credit market conditions. Indeed, every 10 per cent depreciation of the euro should increase EPS of European companies by around 10 per cent.
The sharp falls in both energy prices and corporate bond yields are further positives for the investment case for eurozone equities, which not surprisingly have soared this year: the leading indices in France and Germany, the CAC 40 and Dax 50, are both up by around 15 per cent while the Italian S&P MIB index has soared by 20 per cent. To put this performance into some perspective, both the FTSE 250 and Aim indices have risen by about 11 per cent, albeit boosted by a sharp rally post the Conservative party's win in last month's general election.
Clouds on the horizon
But, as always, there are a few clouds on the horizon to prevent investors from becoming overly complacent, the most pressing being the ongoing stand-off between the Syriza-led Greek government and its EU and International Monetary Fund (IMF) creditors.
This confrontation will shortly come to a head simply because Greece does not have access to funds either to meet the €2bn (£1.5bn) of IMF funding due to be repaid in June and July, nor the €6.6bn of government bonds scheduled for redemption in July and August. A fortnight ago, the Greek government took the unusual step, and one last used by Zambia, to bundle the four debt repayments due this month to the IMF into one aggregate payment of €1.54bn to be paid at the end of June. It's unusual, and buys time for Greece, but it also highlights a gulf between the Troika (IMF, EU and ECB) and Syriza in reaching a compromise agreement with regards to the financial targets and fiscal reforms to be implemented by the government as demanded by its creditors.
Furthermore, the Greek government has total debt obligations of €18bn to meet between now and 20 August, a significant sum in relation to its €322bn of government debt, of which three-quarters is ultimately held or guaranteed by the ECB or other European countries. For example, the ECB has exposure of €83bn to Greek banks under its Emergency Liquidity Assistance (ELA) scheme.
In other words, without being able to tap its creditors for fresh funds - the country's two financial bailouts in 2010 and 2012 raised €240bn, or three-quarters of Greece's total debt obligations - this high-risk game of brinkmanship will either end with Greece defaulting on its debts, and perhaps even being forced into default if the ECB refuses to extend further ELA funding to the Greek banking system, or alternatively there being a last-minute deal being agreed between all parties.
Investors are currently betting on a deal being done to avoid the potential for contagion spreading across financial markets, but it's not a given. The clock is ticking down and Syriza's leader, Alexis Tsipras, now only has a fortnight to negotiate a deal. From my reading of the situation, it now looks like the Greek people, of which 25 per cent of the working population are unemployed but the majority still want to stay in the euro, have elected a government that will ultimately lead to their expulsion from the single currency. In the circumstances, it's worth quantifying the implications of a Grexit.
The impact of a Grexit
Firstly, the ECB would have to be recapitalised as it has lent €83bn to the Greek banks. Economists at investment bank UBS estimate that the European Financial Stability Fund (EFSF) has lent almost €130bn to Greece, and there is also a €18bn liability under the ECB's Securities Market Programme.
True, the financial impact is material, but when spread across a region with north of 400m people, it can be easily contained, especially as the Greek economy only accounts for 1.5 per cent of the eurozone economy. Ben Robinson a partner at European equities fund manager Argonaut Capital, notes that "even assuming there would be zero recovery by creditors, which seems somewhat unlikely and unprecedented, or new money printing, the entire stock of Greek government debt would increase debt/GDP ratios across the eurozone by just 3 per cent".
Mr Robinson also points out that "the ECB's QE programme is a credible backstop to prevent a sustained spike in peripheral sovereign bond yields, and (in the event of a Grexit) the ECB could simply accelerate its bond purchases (to dampen yields and inject liquidity into the financial system)." I would agree, and although I would expect some immediate reaction in financial markets in the event of a Grexit - namely, a euro and equities sell-off, and a spike in eurozone bond yields - I don't think this will lead to anything more substantial. Nonetheless, it's worth preparing yourself for a period of increased market volatility if Greece does default.
Bond market watch
Of course, potential threats to equity market stability rarely emerge from just one front. The second likely cause of short-term volatility could be a prolonged bond market sell-off. We have had a taste of this to some degree already because yields on 10-year eurozone debt have spiked sharply since mid-April, as investors factor in the possibility of reflation in the region, adjusting their inflation and interest rate expectations upwards. In turn, this has knocked bond prices.
In fact, with interest rates so low already, small changes in yields on high-quality sovereign paper have a dramatic impact on prices. For example, with German 10-year bunds currently yielding 0.86 per cent, or 17 times higher than the record low of five basis points in late April, then the price of these bonds have fallen by around 6 per cent. Going higher up the yield curve to 30-year German bonds, and paper losses are nearer 16 per cent in the past seven weeks.
Investment grade bonds that are priced at a margin off the risk-free government bonds have fared better, although there still has been a reversal: the iBoxx € Corporates index of investment grade corporate debt has just dropped into negative territory for the year.
The flipside is that reflation is actually positive for corporate earnings, and in turn supportive of equities. It's the degree of movement in the bond markets that counts most. Bearing this in mind, strategists at Goldman Sachs think that the negative feedback loop from bond markets to equities may be close to peaking, and that further modest increases in sovereign bond yields can be absorbed by equity markets, reflecting the positive reflationary impact on corporate earnings growth. The Dax50 and CAC 40 have sold off by 10 and 8 per cent, respectively, since hitting highs in April, but a healthy correction was overdue as both indices had rallied by around 25 per cent in only four months. In any case, the MSCI European index is currently trading on 15.8 times earnings estimates, hardly a bargain basement valuation, but also one that could yet offer upside if Eurozone corporate earnings get a major lift from an increase in GDP and the weak euro.
I will keep a close eye on developments in the bond market, but at this stage I am not overly concerned. UK investors don't appear that worried as both the FTSE 250 and Small Cap indices are still trading close to their record highs. And that's why I will continue to focus my attention on uncovering special situation Aim-traded and small-cap companies with potential to outperform their benchmark indices over the remainder of this year, and beyond. I also have some valuable clues as to where the best returns can be made.
Confrontation or compromise: Top left: Greece's prime minister Alexis Tsipras. Middle left: Yanis Varoufakis, Greece's finance minister. Bottom left: Christine Lagarde, managing director of the IMF
Playing the long game
Admittedly, the rise in Bank of England base rate I had eagerly anticipated last autumn has failed to materialise this summer. But that's largely because the collapse in the oil price, which contributed to the UK's slide into deflation, has put any chance of a base rate rise on the back burner as far as the bank's rate-setting Monetary Policy Committee is concerned.
But it's worth pointing out that when the weak comparatives from late last year and the first quarter of this year drop out of the UK consumer price index (CPI), then we are likely to see a sharp rise in the inflation numbers. For example, Brent Crude is currently trading a third higher than its January lows. Moreover, with employment at record highs of 31.1m, and unemployment falling to a seven-year low of 5.5 per cent of the working population, it doesn't take a genius to work out that if these trends persist the spare capacity in the economy will fall away sharply.
And with the Bank of England forecasting growth in the economy of 2.5 per cent this year, and 2.6 per cent next, then it's only reasonable to expect wage growth to continue to outstrip inflation for the next year given the tightening labour market. We are seeing this already as average pay for employees, excluding bonuses, rose by 2.2 per cent in the first quarter of 2015 compared with a year earlier, and pay increases have now outstripped the prevailing annual rate of inflation (as measured by the CPI) for eight consecutive months.
As for the timing of the first move in UK base rate, most economists are now predicting the MPC will make their move in the first half of next year, which seems a sensible forecast to me. Bearing this in mind, economists at JPMorgan have back tested the Bank of England base rate cycles in order to identify the best-performing sectors in the 12 months preceding the first rate hike.
Not surprisingly, the best returns have been made from companies in cyclical sectors. These include construction and materials (30 per cent positive return relative to the MSCI UK index); housebuilding (26 per cent return); automobiles (24 per cent); leisure, restaurants and hotel (19 per cent); media (15 per cent); and consumer durables (12 per cent). Shares in banks have performed well in the period between six and 12 months before the first rate rise, but not in the six months before. Non-cyclical stocks have performed badly in general. For example, utilities significantly underperformed throughout the 12-month period before the first rate rise and telcos performed badly in the six months prior. The food sector, both retailers and producers, produced negative relative returns.
These sector trends are well worth making a mental note of in anticipation of the first move in bank base rate belatedly occurring in the first half of last year. I certainly have done so. The sectors to focus on after the first base rate rise are worth considering, too, but that's for another day.
MORE FROM SIMON THOMPSON...
At the end of April, I published an article with all the share recommendations I have made this year. Since then I have published articles on the following companies:
■ Marwyn Value Investors: Buy at 220p, target price 260p ('Exploiting a value play', 5 May 2015)
■ Pure Wafer: Buy at 113p, target 140p to 150p; Paragon: Run profits at 440p, but buy on a confirmed breakout above the 445p and new target of 500p; 600 Group: Buy at 16.5p, target 24p; Fairpoint: Buy at 127p, target 190p; AB Dynamics: Buy at 207p, target 230p ('Repeat buy signals', 11 May 2015)
■ Globo: Buy at 56p, target 69.5p; Greenko: Hold at 70p; Pittards: Buy at 128p ('Breakout looms for mobile wonder', 12 May 2015)
■ Macau Property Opportunities: Buy at 214p; Dragon-Ukrainian Properties & Development: Hold at 28p; Raven Russia: Hold at 53p ('Overseas property plays', 13 May 2015)
■ Trakm8: Run profits at 135p; Redde: Buy at 120.75p, target 140p; STM: Run profits at 45p, but conditional buy on close of 48p and new target of 60p ('Smashing target prices', 14 May 2015)
■ Bilby: Buy at 75p, target 100p ('Buy to build' growth play, 18 May 2015)
■ Bioquell: Buy at 148p, target 170p to 185p; Somero Enterprises: Buy at 140p, target 185p; KBC Advanced Technologies: Buy at 109.5p, target 165p; Inspired Capital: Hold at 14.25p ('Three value plays', 19 May 2015)
■ Renew Holdings: Buy at 315p, target range 350p to 375p; Manx Telecom: Buy at 198p, target 210p ('Renewing old acquaintances', 20 May 2015)
■ Marwyn Value Investors: Buy at 228p, target 260p; Charlemagne Capital: Hold at 13.5p; Bloomsbury Publishing: Hold at 178p ('Lights, camera, action', 21 May 2015)
■ Anite: Buy at 91.5p, target 110p ('Testing a breakout', 26 May 2015)
■ Character Group: Buy at 415p, target 525p ('Playtime', 1 Jun 2015)
■ Tristel: Run profits at 96p; Pure Wafer: Buy at 123p, target range 140p to 150p; Crystal Amber: Buy at 153p ('Hitting target prices', 2 Jun 2015)
■ B.P. Marsh & Partners: Buy at 150p, target range 170p to 180p; Moss Bros: Buy at 110p, target range 120p to 130p; SeaEnergy: Sell at 15p ('Exploiting a valuation anomaly', 3 Jun 2015)
■ Globo: Buy at 59p, target 69.5p; London & Associated Properties: Buy at 38.5p; Greenko: Hold at 44p ('Catalysts for share price moves', 4 Jun 2015)
■ Burford Capital: Buy at 148p, target 190p ('Legal eagles', 8 Jun 2015)
■ 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 £2.95 postage and packaging. Simon has published an article outlining the content: 'Secrets to successful stockpicking'
