Europe's equities transfusion

PORTFOLIO POINT: It won’t be a quick markets fix, but the stimulus packages in Europe and the US will be good for the Australian sharemarket and equities generally.

The long-anticipated announcement of a European stimulus package should deliver a much-needed transfusion to the Australian sharemarket over time. I go into this in more detail below, but before I get there it’s important to get an overview of the current landscape.

Having spent my last two weeks in Ireland and Spain, it may be claimed that I have been in the epicentre of the European debt crisis. Of course, such a claim dismisses the relevance of Greece or denies the importance of the financial and political centres of Berlin and London.

In Europe my main objective was to have a holiday, but I did keep a watchful eye on the news wires, political commentaries and financial markets. In doing so I am rather pleased to report that some of the wild predictions made way back in May 2010 are being played out before our eyes.

The conclusion I drew then, and maintain today, is that the sovereign debt that resides across Europe, the US and Japan will not be repaid. There is absolutely no way that it can be repaid as it is simply too large. Whilst it may not be as high as the sovereign debt and war related obligations that existed after World War Two, it is too large to be repaid given the mature economic profiles of the major creditor countries.

There is no discernible growth opportunity across Europe emanating from a depleted infrastructure as there was after 1945. Western Europe is well serviced and capital expenditure by governments is not required. So growth substantially seen from government capital investment is not an opportunity.

At the various finance meetings that occurred in Europe over recent weeks there were discussions regarding the forgiveness or restructuring of debt for both Ireland and Portugal.

There seems no doubt to my mind that others such as Greece (should it decide to remain in the euro), Spain, Belgium and possibly Italy will line up for some forgiveness as well. However, as I noted over two years ago, the forgiveness cannot occur if it is against the private debt held by the major banks and financial institutions.

The restructuring losses would blow the capital of these entities away. They would fall into government hands and the debt obligations would end with the taxpayer.

So Mario Draghi, on behalf of the European Central Bank (ECB), took the only possible course and the important first step when he announced unlimited buying of short-dated European bonds with newly printed euros.

However, there is a catch and that is the requirement for the beneficiary countries to agree to austerity budget programs. Thus, for Ireland to get ECB bond buying support, it needs to agree to reign in its budget by slashing expenditure and raising taxes. Ireland has been doing this for some two years already and now needs a clear way forward to reduce its debt, otherwise its voters may turn to the political IRA to join the government coalition.

Further, a massive amount of bonds need to be bought across Italy, Spain and possibly even France for the debt restructure to commence and be fair. For massive amounts of bonds to be restructured then, these can only be held by the central bank or other like-minded public entities. What is a massive amount? Well an unlimited amount, and that is what Draghi proposed.

There is another condition (or catch), and that is the proper regulation of the financial markets and institutions. Proper financial regulation is important, because without it there is no stable way forward and there is the likelihood that some banks will implode again at a future time – such is the unchecked greed that still resides in many financial intermediaries across the world.

The massive quantitative easing program undertaken in Europe was just what the US Federal Reserve (Fed) and US Treasury had been seeking for at least the last year. But when it came, it required a quick US response because it threatened to push up the value of the US$ and snuff out the weak US recovery. So the US, through the Fed, devised its own QE3 to counter the currency effects of the euro printing.

Ben Bernanke announced the US$40 billion per month purchasing of residential mortgage-backed securities under the primary claim of an attack on high US unemployment. I am not so sure. Indeed this strategy, along with the Operation Twist (selling short treasury debt and buying long), should hold US interest rates and the currency down, but it is not certain. Indeed, if confidence in any form returns to the European bond market then US bonds look ridiculously priced as a safe haven asset! This explains the slight increase in yields on US (and also German) long-dated bonds in the last week.

German 10-year bond yields

Click to enlarge

So the one big observation from the above is that there is currently no basis to claim that the bond markets of Europe or the US are orderly or correctly pricing the risk of inflation, restructure, forgiveness or default. There is now so much interference in these bond markets by central banks that the concept of a risk-free rate of return is currently debased. This observation has interesting ramifications for equity markets everywhere.

So what is the outlook for the world economy and the Australian sharemarket?

There are four issues to consider in responding to the massive QE programs.

• Will it have a positive effect on the European economy?
• What will an unrelenting QE do for the US economy?
• Will QE in Europe and the US help stimulate trade between the world and China?
• Is Australia a beneficiary or a victim of overseas developments?

These are all vital questions when I consider the structure of equity portfolios. To a significant extent, all of the above questions and their answers are interrelated. Further, it is a complicated set of circumstances and we are very much in unchartered waters. That is, whilst the restructuring of debt through QE programs was arguably very predictable, the consequences require much thought and some speculation. So here is my view.

Europe

The European financial markets will benefit from a belief that European countries will not default and drop like dominos. There is likely to be another surge in confidence should it become clear that the private owners of European bonds are definitely not at risk. However, it will create a two-tiered bond market and it may perpetrate the mispricing of risk. In particular, bond markets may completely misprice the risk of future inflation.

As for the European economy, I do not see any significant recovery. Low or negative growth remains a feature as taxes rise across the continent and there is very little stimulation that governments can undertake.

Lower interest rates are not good for retirees or those reliant on investment interest income. This will have a dampening effect on the consumption of an ageing population.

The fiscal union of Europe will be a convoluted process, but its ultimate goal must become the reorganisation of European manufacturing through taxation zones and wage restructuring. Such an outcome will require a massive mindset shift, but it is possible. Proof of this is seen in Ireland where wage rates are being adjusted and the country retains a 12% corporation tax on international export focussed companies.

In summary there is much to be done in Europe before reasonable growth returns.

The US

The US economy has the fiscal deficit hurdle to deal with and it will be addressed by the next President – whoever he is. In some respects the legislated cliff is absolutely necessary to get the US away from its QE binge program.

The argument that the US bond market is a “safe haven” will be tested if the European bond market stabilises and the fiscal deficit is not brought down to below 5% of GDP in 2013. I do not see the QE program of the US being a panacea, but I do see the legislated tax increases and government expenditure restraints as being positive for the US longer term.

A weak $US, a focus on bringing back jobs in manufacturing, the development of an energy industry and an agreement for US corporations to pay a proper amount of US corporation tax, are likely developments in the coming year. However, none of the above will be positive for growth in the US in 2013. Thus, like Europe, the US is confronted by a low growth outlook.

China

In China the change of administration and the confirmation of the next leadership will occur in coming months. China retains an immense ability to stimulate its economy through targeted government capital investment. Some of this was unveiled in recent policy announcements.

So arguably, China remains as the growth engine of the world but it is being hampered by the inability of the western world to grow. The growth in external trade by China has been important and when this was combined with targeted capital investment and speculative investment it provided a growth mix of towards 8% of GDP.

Clearly with Europe slowing and speculation being curtailed, the growth of China will also slow – but it is still substantially ahead of the growth of Europe, US and Japan.

Australia

Thus, Australia appears to sit meekly waiting for world growth to appear. It will be a long wait but it does not spell bad news for the Australian sharemarket or equities generally.

The resolution of the debt problems in Europe will increase confidence and stimulate investment flows into equity markets across the world. The relative attractiveness of shares over bonds is a key issue.

Indeed, specifically, the Australian equity market is supported by its dividend yields, which are relatively attractive compared to bonds. Unfortunately, a fair amount of the investment flows will be indiscriminate (i.e. indexing) and not be “value” focussed. That is a feature of asset allocation across the world as too much investment capital has to constantly find a home. The fact that two-year yields on US treasuries are virtually zero is testament to that observation.

I maintain that the more discerning investment capital is that which targets the maintainable growth and sustainable yield of individual companies, as exhibited by historical performance.

I recommend that investors maintain a discipline to buy highly profitable companies at a significant discount to value. This investment approach may underperform for short periods and particularly when the market indiscriminately rises. However, value-based investing will over a longer term continue to produce superior returns for patient investors.

So investors should expect a steady uplift in the Australian equity market over the next year. This is not a bullish assessment but just a view based on the poor yields that are offered by so called “risk-free” assets. As I noted above, the debasement of the bond market suggests value in the equity market.

John Abernethy is the chief investment officer at Clime Investment Management. Register for a complimentary portfolio assessment.

Clime Growth Portfolio – Prices as at close on 20^th September 2012

Start value: 111,580.24

Current value: $121,646.29