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Un été en Europe

Summary  - The strongly developing consensus appears to be pro-Europe relative to the US. A stronger Euro and a negative view on US equities is part of that. The political and health situation in the US is beginning to undermine investor confidence. The European deal has boosted the outlook on this side of the Atlantic. However, long periods of Euro and European equity outperformance versus the US have been rare. The last time was between 2001-2008. The key is whether the post-Recovery Deal period generates the same growth and confidence as those early years of the single currency. For now Europe is cheaper and the short-term news flow is better. Happy Summer.  

Euro-up

The Euro has benefitted the most from the agreement made last weekend to establish the European recovery fund. Against the dollar, the Euro has risen by 9.2% from the low reached on March 23rd (the day global stock markets also bottomed) and it is up 10% against sterling. The rally has ben long-hoped for by dollar bears who have activated a number of arguments for why the US currency should weaken and have now got a more positive European story to add to the arsenal. The agreement on the recovery fund allows fiscal transfers and provides for some mutualisation of Euro Area debt. Potentially this means that joint fiscal policy and the establishment of a unified debt market are realistic future developments. Symbolically this is huge in a similar way to Mario Draghi’s pledge in 2012 to do whatever it takes to save the euro. In theory, and maybe in practice, European policy makers now have an additional large and effective policy tool to deal with future periods of economic crisis.

Good for credit at the margin

In the short-term the macroeconomic implications of the deal depend on how quickly the funds are disbursed and the types of projects the funds are used to finance. On top of the policies of the European Central Bank (ECB) and national fiscal initiatives, the outlook is certainly further improved by the deal. Marginally this is supportive for the currency but equally we should get another big fiscal stimulus from the US soon, which by the same logic should be dollar positive. More importantly, the deal is further insurance against systemic risk in the Euro Area. So along with benefits for the Euro currency, credit asset classes also win out of the deal – both at the corporate and sovereign levels. Prior to the crisis, the asset swap spread on the ICE/BofA European Corporate Bond Index was around 60 basis points (bps). Today it is around 100 bps. Further tightening is likely as a result of the boost to confidence the deal brings, and this should occur across the ratings spectrum. On the sovereign side, spreads should also narrow further. Italy will be the biggest recipient of funds from the Recovery and Resilience Facility. Its deficit and issuance levels will not increase as much as what is spent in Italy. This improves fiscal dynamics somewhat, as will the ensuing lower borrowing costs for Rome. The spread between 10-year Italian government and German government bonds was last as low as 100 bps at the end of 2015. There appears no reason to think it won’t get there again in the months ahead. Personally, I don’t think it is a great trade though. Italy’s fiscal and political risks are still there, but momentum could push yields lower.

Further gains ahead?

So reduced systemic and credit risk, improved debt dynamics for the most fiscally challenged and a marginal improvements in the growth outlook. These are the positives for the Euro. The political symbolism and the potential to jointly react with fiscal policy is perhaps the most important. The Euro rallied strongly following Draghi’s 2012 comments, moving from US$1.20 to US$1.40. The current rally started from a lower base and probably has further to go – certainly into the US$1.20-1.25 range. It has momentum and arguments for a strong dollar don’t hold much water at the moment. There is political and policy uncertainty, with the election looming and the real risk of a second dip in national economic activity in response to the pandemic.

Not guaranteed

The view needs some perspective though. While the headlines have been about the deal being a “game-changer”, it should also be noted that the agreement was not easily reached. A number of countries appear to have been reluctant participants. It sits within the EU’s 7-year budget process and most informed observers suggest that topping up the €750bn facility is extremely unlikely before the end of this period, unless of course there is another crisis. Secondly, Europe does still have a growth issue. At the end of 2019, Euro Area GDP was only 9.5% higher than it had stood on the eve of the Global Financial Crisis at end-2017. In comparison, the US GDP level was 21% higher. Current consensus forecasts have 2022 real GDP growth in the Euro Area at 2.2% and 2.9% in the US. With Europe’s export sectors already badly impacted by trade sanctions and the disruptions caused by coronavirus, the last thing they need is a very strong currency. Maybe crossing the Rubicon of fiscal transfers, having a stronger institutional economic policy framework and banishing Euro break-up fears will allow trend growth to improve. Getting a Brexit-deal might also be a positive. This is what investors appear to be betting on.

Capital flows

Currencies are ultimately driven by capital flows and for any rally to persist these have to be more than short-term and speculative. Are global investors going to increase their allocations to European equities? While past performance is no guarantee of future returns, the fact that the S&P500 has had annualised total returns of almost 6% compared to 2.1% for the EuroStoxx index over the last twenty years is a huge barrier to get over if we are going to see American investors swap some of their FAANGS for European industrials and banks. There may be a reason for owning Europe over the US for defensive reasons – European indices have a lower beta to the US market – but that is not exactly in the spirit of a European renaissance.

US growth

Being positive on the Euro is a consensus view at the moment. Being negative on US equities is starting to become a consensus view as well. The US is more of a growth market. A lot of people express incredulity at the performance of the NASDAQ index but its constituent companies have delivered a compound earnings growth rate of 10% per year since 2010, compared to just 0.7% for the EuroStoxx index, 0.9% for the German DAX index and -0.9% for the CAC-40 (using Bloomberg 12-month trailing EPS data). Of course, the NASDAQ is dominated by the big tech companies – the top 5 account for 40% of the market capitalisation of that index. The growth of these companies has exaggerated the overall growth profile of equity earnings for the US, but even broader and less tech heavy indices have a superior record relative to Europe. According to IBES data on trailing earnings-per-share, the S&P500’s growth rate has been more than double that of Europe since the launch of the Euro in 1999.

US risks

A persistent outperformance of European equities requires a number of factors to come together. First the global recovery needs to be reassured by progress on the virus and an upturn in global trade and investment. Second, this needs to be reflected in a more pronounced “value” outperformance, confirmed by some steepening of risk-free curves and a strong performance of lower rated credit. On the US side concerns about the policy environment in the wake of a Biden victory in November’s presidential election need to further materialise. Given the dominance of big tech, this could come from proposals directed at increasing the tax take from those companies. The Alternative Minimum Corporate tax and increasing the tax rate on revenues of US-foreign subsidiaries could reduce after tax earnings for these firms. Efforts to address the monopoly nature of these firms might also be seen. The combined health and economic impact of the virus could also turn out to be worse and more prolonged in the US relative to Europe.

NEU bonds

One of the features of the European deal will be a big increase in bond issuance by the European Union. If all the €750bn is raised via the bond market, investors will be able to tap into a new, liquid and high quality asset. The face value of the European government bond market is around €6 trillion so the new EU bonds will represent around 12.5% - making them bigger than the outstanding Dutch and Belgian markets combined and roughly 85% of the size of the Spanish government bond market (according to the size of the ICE BofA government bond market indices). The emergence of a new liquid asset will be welcome by banks, pension funds and insurance companies who have all been insatiable demanders of duration. What it will do to the pricing of other curves remains to be seen. What it won’t offer is a great return, as yields are likely to be very, very low. Still, improving the capital market infrastructure will help strengthen the Union and its economy at the margin. It will, however, be sometime before the EU bond challenges the dominance of the $11 trillion US Treasury market.

Bar-bell

It’s reasonable to conclude that the deal is good for Europe and will help European assets. Being long the Euro versus the dollar, yen and sterling might be the best bet for a decent short-term return but I am not convinced we are in a multi-period rally unless growth materially rises. There are reasons to be concerned about the US but the reality is that generally banks are stronger and tech is where the growth is and will continue to be. Europe could outperform for a while if we get a cyclical value-led recovery and the crystalisation of political concerns in the US. Indeed, these might be quite malign for equity investors going into Q4 given the ongoing fragility of the economic recovery and the need for investor confidence to continue to be shored up by (promises of) further policy support. With monetary policy on hold everywhere equity and multi-asset investors should look at being exposed to duration assets to hedge. The NASDAQ is volatile. So far in 2020 it has also had a -0.4 correlation of daily price returns to the over 15-year US Treasury index. If the NASDAQ represents an extreme of “growth”, the long-end of the Treasury market represents the risk-off antidote. Putting them together, so far this year, would have lowered risk and increased returns relative to either an equity only or bond only strategy. The key is hedging one asset with a high price volatility with something else, negatively correlated, with an similarly higher price volatility.

Down to the wire

With one Premier League match left, there is much to play for. Two out of Manchester United, Chelsea and Leicester City will claim a Champions’ League spot for the 2020-2021 season. United only have to draw with Leicester. None of the three teams have been particularly convincing of late but Leicester perhaps have been the least. IT would be a great achievement for United to claim 3rd or 4th place given the start to the season they had. If they do, I will head to Cornwall for my 2020 holiday a happy fan. It’s usually Spain, but not a European summer this year. Cornish pasties and mackerel instead of paella and sardinas!

Stay safe and have a good weekend!

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