|Summary: The economic recovery across Europe has been remarkable, and the good news just keeps coming. But the good news could change if capital inflows continue at their current pace, and further euro appreciation could exacerbate regional disinflationary trends.|
|Key take-out: More crowded equity and bond markets could spark painful profit-taking if European momentum does not continue to at least meet expectations.|
|Key beneficiaries: General investors. Category: Investment strategy.|
While investors are nervously focused on emerging markets, a different, more positive trend has been curiously developing in Europe.
Spanish 10-year government bond yields are now trading only one percentage-point above US 10-year Treasury yields, despite a much worse Spanish economic backdrop that includes an unemployment rate near 27%. The euro, meanwhile, is trading at nearly 1.37 against the dollar, well over longer-term historical averages closer to 1.20.
Is such strength in European assets justified, or are these regional markets getting ahead of economic reality?
The optimists find plenty to justify their bullish views: consider news just in the last two weeks. Further Euro-area growth momentum was suggested by business confidence reaching its “most optimistic” level since mid-2011. Ireland saw its government debt regain investment-grade status by Moody’s, while Spain received €40 billion worth of demand for a €10 billion-euro bond auction.
Such constructive developments have helped European markets start 2014 on a stronger footing, with foreign capital continuing to hurry in. The first weeks of January have seen European equities, and in particular, peripheral EMU equities, outperform (US equity losses year-to-date have been about double those recorded by Spain’s IBEX equity index).
European bonds have seen similarly impressive trends. Despite the increased supply, demand has been so great that Spanish 10-year government yields have fallen to their lowest levels since 2006. Other peripheral bond yields have similarly fallen.
Following European Central Bank President Draghi’s now-famous pledge in mid-2012 to do “whatever it takes” to keep the euro intact, risk premiums in European assets have been gradually receding. At the same time, government efforts to improve economic fundamentals have started to bear fruit. Budget deficits and debt levels have narrowed as a percent of GDP. And with the exception of Italy, real wages have come down significantly, helping make economies more competitive.
With such trends in place, the ECB has felt little need to take additional, large monetary steps to support growth or fight deflationary risk. While the US Federal Reserve’s balance sheet has steadily risen since the financial crisis, and now tops $US4 trillion, the ECB’s balance sheet has been declining since mid-2012. The ECB plan, it appears, is to hope that tighter fiscal policy and the passage of time (rather than Fed-like monetary easing) would prove sufficient to ensure sustained growth.
So far it looks like the central bank’s somewhat laissez-faire plan is working. For now, good news is good news for Europe, and I am comfortable maintaining our overweight to the region’s large-cap equities. Capital inflows are boosting business and consumer confidence, and that confidence is leading to greater economic activity.
I would not rule out that Draghi’s plan truly succeeds – that is, that Europe’s economic recovery will not only be sustained but could even gather further (modest) momentum, helped in part by relative improvements in growth overseas and slow but continued progress to address structural weaknesses in the union.
But managing money means always thinking about risk. And in Europe’s case, I see a risk that good news on capital flows could – eventually – turn into bad news for the EMU economy, especially should inflows continue at their current pace.
More crowded equity and bond markets could spark painful profit-taking if European momentum does not continue to at least meet expectations. Meanwhile, further euro appreciation could exacerbate regional disinflationary trends as well as weaken the strong man of the monetary union, Germany, given the latter’s heavy reliance on exports.
I continue to enjoy Europe’s somewhat unintuitive market strength, but stay focused on yields and the euro, alongside the ECB’s policymaking stance. I do not want to be the last one to realise that good news has become too good, or that the ECB’s “hope and wait” policy is just not enough.
Rebecca Patterson is chief investment officer of Bessemer Trust. This article was first published by Barron’s, and is reproduced with permission.