Saint Francis of Assisi once reminded his congregation to “preach the gospel at all times, and, when necessary, use words.” Apparently, the European Central Bank’s president, Mario Draghi, slept through that sermon. In what is now famously known as his “Do Whatever It Takes” speech in July 2012, Draghi used rhetoric rather than real policy action to resurrect markets.
It worked miraculously. Eurozone assets experienced a Lazarus-like revival, and peripheral-country sovereign spreads narrowed dramatically. That is, until recently. Now, worldwide stock markets are stalling, driven by a renewed focus on the euro area’s secular stagnation.
Central bank con game
Where to next? To be sure, central banking is a confidence game. And strong convictions from policymakers are important. But you cannot summon an economic recovery by simply saying that it will be so.
Of course, the ECB has begun to act, with a raft of stimulative measures announced in recent months. Importantly, Draghi has committed to expand the ECB’s balance sheet by as much as €1 trillion. Serious policy action is now in play.
Why then are investors not more hopeful? Figures from Morningstar show that investors pulled $4.7 billion out of European equity funds and ETFs in the third quarter.
While it’s true that markets have become accustomed to the ECB talking a big game but delivering little (where is Draghi’s bazooka?!), a sentiment shift is underway.
The previous narrative was that the ECB was simply behind the more successful U.S. Federal Reserve. In time, as the ECB more closely emulated the Fed, cyclical vigor would show up. It was simple reasoning and a convincing story – and it drove a lot of inflows into eurozone assets.
But that’s the problem with financial markets – they refuse to supply tidy endings or to validate simple theories.
Eurozone’s deep structural problems
The reality is that the eurozone faces a number of structural issues that were uniquely driven by the creation of a common currency. Unsustainable debt burdens, chronic lack of competitiveness in core countries such as Italy and France, and a highly leveraged banking system are all the freakish offspring of the euro project itself.
Further monetary fidgeting or new policies from the ECB are unlikely to resolve these issues any time soon – even ballooning the central bank balance sheet by trillions.
Still, it’s important not to become mired in euro pessimism. The important issue for tactical ETF asset allocators is to understand the risks and the opportunities. Heightened central bank activity always creates both. From that perspective, consider a more hopeful investment outlook:
The eurozone is not an economic island. Contrary to sagging wages in the West, Asian incomes have been on a tear over the last decade. The OECD forecasts that 80% of the growth in middle class spending globally through 2030 will be driven by Asia. European consumer companies are ideally positioned to benefit from this trend, where brand cachet is all-important (and often carry a better status than American rival companies). Other emerging economies are similarly set up for a large increase in discretionary spending. For example, India, Indonesia, and the Philippines are all reaching income levels (GDP per capita of about $5,000 on a PPP basis), while demand for European goods exploded in China.
Valuations matter. The eurozone has been accused of “turning Japanese.” While it’s true that the new, dismal normal of the eurozone is sluggish growth and more frequent recessionary relapse, the probability of eurozone stock markets following the Japanese experience is extremely low, simply because valuation is the best predictor of longer-term returns. During Japan’s epic decline, equity valuations started from lofty levels, and debt was concentrated in the corporate sector. Those conditions are not present in the eurozone today.
Currency depreciation has gloriously arrived. Euro strength in the past two years may have represented faith in the longevity of monetary union, but it has created enormous problems for export-oriented companies (not to mention globe-trotting ETF strategists). With major policy divergence between the Fed and the ECB, a new era of currency depreciation is upon us (see my article, “Position now for a weaker euro”). Looking toward next year, the benefits of a weaker euro and potentially less austerity will feed through into the data and show up as improved profits.
Looking ahead, the coming weeks will almost certainly be volatile. The ECB published the results of its yearlong eurozone bank audit on Oct. 26, which saw 25 European banks still under stress. And Mario Draghi last week again indicated the ECB would extend its asset purchase program if inflation slows any further, much to the delight of equity markets everywhere.
Will all this bring the euro drama to a thundering climax? If you read French newspapers, that certainly seems to be the case. But it’s hardly likely. Most of this is political theatrics, similar to the “fiscal cliff” in the U.S. (yes, the one that led to a monster rally in the S&P 500 Index).
Investors should stay awake and alert to both what the ECB is saying and doing. The time to overweight currency-hedged eurozone equities is likely near.
Tyler Mordy, CFA, is President and Co-CIO for HAHN Investment Stewards, engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. A version of this article first appeared in ETF.com. Used with permission. You can reach Tyler by phone at HAHN Investment Stewards, toll-free 1-888-419-6715, or by email at firstname.lastname@example.org.
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