The year to date trend of European equity out-performance continued last week. Is it really as simple as allocating to the markets where the central bank is cranking up the printing press with fundamentals relegated to the back seat? For the moment, it seems so! On that subject, China cut its main interest rate by 0.25% this morning - more below.
We don’t really have any problem with the relative advantages of owning European equities over those in the US during the early stages of the ECB QE programme. To back this up with a modicum of fundamental analysis, European equities are also cheaper than in the US. We also believe that Europe will be a bigger beneficiary of the cheaper oil price and the corporate sector in Europe will broadly benefit from the weakness of the Euro in recent months. As well as global investors chasing the QE trade, European investors facing the alternative of zero or negative yields on trillions of assets will surely consider allocating some to equities where a 3% yield is certainly not uncommon.
In the very short term, we would urge a little caution in chasing European equities. Not only have they risen by nearly 20% from the early January low, the rise has taken the main indices to overbought levels on traditional momentum indicators such as relative strength and simple moving average models.
The main reason that we are not more bullish on European equities is that US equities, traditionally the global bellwether, continue to look laboured whilst their economic fundamentals continue to deteriorate. We have been considering two negative macro drivers that affect both the economy and the corporate sector in the US, namely the bust in the energy sector and also the strength in the US Dollar. Of course a weaker oil price is good for consumers and should help the economy over time. The flip side to this, and a shorter term consideration, is that the energy sector is much bigger than it has been for most of the past three decades thanks to the shale boom. The risk therefore is that the collapse in the oil price has a greater short term impact on the whole US economy simply because the energy sector is much bigger now and also accounts for a much larger share of capex (which is collapsing).
Now if it was only the negative aspect of the drop in energy prices that was of concern, then we think that would be more manageable. However, the continuing strength in the US Dollar will not only be a significant headwind for the export sectors but it raises the possibility of an emerging market crisis as US Dollar debtors struggle to service debt with depreciating local currency revenues.
We highlighted back in January how US corporate earnings growth actually can be the lead indicator of the US economy. The chart below, published this week by Soc Gen, shows this in a slightly different way than we did, but the message is the same. US earnings are projected to start falling year on year and this could easily lead to a much weaker outcome for the economy than the consensus believes possible. Of course, a slowdown may not occur, but the historical evidence of the fallout from a collapse in the (now much larger) energy sector and the strong US Dollar should not be so easily dismissed.
On the currency front, we all know just how strong the US Dollar has been against the Yen and Euro and pretty much every other major currency. What seems to be a new dynamic that will make matters worse is that the Chinese Yuan is also now losing value, as seen in the chart below of the 12 month outright rate. We have written about the risks surrounding the Chinese economic slowdown, and of course the bulls point out that cutting both interest rates and reserve requirements is bullish of risk assets. We thought that the Chinese authorities would also look to quietly weaken their currency, and why not? Isn’t everyone else except the Swiss doing so? This would appear to be part of their plans as China cut rates this morning in an attempt to offset weakening growth and deflationary concerns. This fits with our view that they will employ all available tools including currency weakness.
Whilst a weaker currency will help Chinese exporters, in the big picture, the risk is both a further deflationary pulse from abroad that could hurt the US and also risk the return of currency wars and related trade wars.
So in this complicated world which seems to get simplified when central banks print money (just buy the dip, stupid!), we do worry that the headwinds are increasing for both the US economy (short term before the potential benefits of lower energy prices for consumers) and the corporate sector. If the Fed chooses to raise interest rates in the next few months, this will just add to the headwinds.
Our view is that the US economy will disappoint in 1H 2015 and that the resulting weakness in corporate earnings will hurt the stock market. This may well cap European equity performance although we still expect Europe to outperform. If we are right (and we remain in the minority on this), then the Fed has few manoeuvres left. Rates at zero and QE now off the table means they cannot do anything other than use soothing words. We continue to believe that the risk to US equities is rising, and now is not the time to be taking risks.