The realisation that the Euro zone economy had come to a standstill and was on the cusp of deflation*, combined with an underwhelming reporting season and the end of QE in the US looming on the horizon**, was behind this summer's correction. However, since 2009 each time things have started to look bad, investors have put their faith in central bankers to bail them out. So, two weeks exactly before central bankers met in Jackson Hole, the general view took a 180 degree turn: "help would surely be on its way again". The worst quintile in terms of share price performance in this mini correction became the best quintile in the last three weeks of August and vice versa. As we had considerably reduced our cyclical sensitivity, the Fund displayed very little volatility throughout this latest spat between bulls and bears.

The communication back channels of the ECB must have been working red hot last month, because every single investment bank in town was pounding the table with their supposedly home-grown view that QE was on its way. As they were all pushing the same message with exactly the same details, I had gathered that what was presented somewhat misleadingly as the independent analyses of some economists, was in reality a message that the ECB wanted to deliver to financial markets before it became official.

Draghi is obviously extremely concerned about deflation anchoring in investors' minds in Europe, and what this new injection of liquidity can achieve, apart from fuelling further asset price inflation, is to generate a bit of imported inflation via the weakening of the Euro. How much will depend on how stronger the dollar can get and how commodity prices are going to react, and in any case, the impact will be short-lived, because in the absence of wage inflation, the CPI will quickly flirt back with the zero level. There could also be an impact on the real economy if governments decide not to allocate the savings coming from a reduced interest bill to accelerate budget deficit reduction.

I had reduced the Fund's cyclical exposure steadily since April/May when I started to worry about weakening leading indicators in The Euro zone. However, I am starting to turn more hopeful about economic growth now on the continent. First of all, the corporate earnings cycle seems to have troughed in Europe. Earnings forecast revision has come down to a trickle (-1% over the last 3 months) and reported earnings have in fact started to rebound though very modestly (+2% increase in 12 months trailing earnings in Europe). The expected weakness of the Euro will help exporters. With LTTRO, credit will ease, though we do not know whether at this stage there is much demand for credit however low rates might be.

However, the most important piece in the jigsaw is that Germany is losing its grip on the direction of the economic policy in the Euro zone. Draghi is now convinced that the absence of reflation in Germany is as much part of the problem as the reluctance of France and Italy to implement much needed reforms. Hence, the tension between the chairman of the ECB and the German finance minister***. He is joining the camp of the IMF which has been making this same analysis for some time now. I believe that both Italy and France will openly ignore the budget deficit targets. Renzi's aura is steadily waning as he is failing to deliver reforms (especially the one on the electoral law which is seen as the necessary first step before overhauling the entire country). He might be tempted to keep public opinion on his side with a bit of fiscal largesse.

Hollande is in a much more desperate situation. Rarely has a politician been so vilified/ridiculed/hated/despised in absolutely every quarter. With only 13% of citizens backing him, according to a recent poll, he has probably established a record in the history of Western democracies. If he has a bit of survival instinct left, he will put an end to any fiscal headwind while trying to placate the Germans by spinning off as good a story of reform as possible. However, if he cannot placate them, too bad! What does he have to lose?

In any case, with the sudden realisation that her own economy has grown to a halt because it is running out of potential buyers for her "made in Germany" goods, Angela Merkel will be much more on the defensive that she has been over the years. She was calling the shots because she could sow division among her potential opponents, playing one country against another**** and being fully supported by the ECB in doing so. However, the situation has changed. She runs a coalition government, the economy is now longer growing and she is increasingly isolated.

Inflation in the EZ was 0.4% for July
** October
*** So much was clear in Schauble recent interview on Bloomberg TV
**** France against Italy for example, when an enormous spread opened up in 2011/12 on government bond yields

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Lionel Rayon

Lionel joined Schroders as part of the acquisition of Cazenove Capital in the summer of 2013, having been at Cazenove since 2005. He is a senior member of the pan-European equity team and manager of the Schroder ISF* European Alpha Absolute Return (circa $1 Billion AuM). He is also responsible for developing and maintaining a fundamental and valuation screen of European stocks. The screen forms the basis for generating ideas for potential further detailed investigation by the European team within the framework of their disciplined Business Cycle Approach. Lionel joined from Citigroup where he was a Director in the European Tech Research Team. Prior to Citigroup, Lionel had been with Schroders Securities, as a French specialist, Nomura Research Institute, as a metals & mining specialist, Enskilda and Chevreux de Virieu. Lionel graduated from Indiana University (MBA) and Institut d'Etudes Politiques de Paris (BSc economics & finance). He has 20 years of equity research experience.

Website: www.schroders.com


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