Commentary:
Yesterday’s post generated quite a bit of traffic, but nothing in terms of comments, which is a bit unusual. Interestingly, TMM’s post also did not appear to have many comments, which is unusual. I’m not sure what to make of that – maybe people have already made up their minds or maybe there is a lot of uncertainty still.
Anyway, I wanted to talk a bit today about European equities, proxied by the Eurostoxx 50 index. As most readers are probably aware, European equities performed quite well in 2012, marginally beating the S&P 500 in local price terms. Much of this has been driven by expectations of a bounce in earnings as the Eurozone gradually exits recession. On a forward basis, the index is actually trading at the richest level since early 2010. It appears that the market is expecting a somewhat ‘normal’ post recession bounce in earnings here, essentially pricing in expectations of much higher earnings > 1 year out.
There is something missing, however. Historically, index prices lead consensus earnings expectations by between 3-6 months. That’s roughly inline with conventional thinking, and the chart below confirms:
Here’s the rub. By those conventions, earnings expectations should be turning by now. But they haven’t. In fact, they are still going down. The 3m change in 1y forward earnings estimates has been negative, and the momentum is getting worse:
Now, analysts could certainly be slow in revising their estimates here. But the macro data does not support the idea that they are wrong. The Eurozone Manufacturing PMI (blue) has been below 50 for almost a year and a half now, and the 4Q uptick appears to be stalling.
In conclusion – this divergence between prices and estimates isn’t enough to say anything definitive. But the timer is ticking. One of them will need to change direction, and soon.
Notable:
- Earnings season starts tonight with Alcoa.
- The press reported that Japan will use part of its foreign exchange reserves to purchase ESM bonds. The first round of purchases is likely to take place today. Finance minister Taro Aso told reporters that along with ESM bonds, other euro-denominated government bonds are to be considered as key investment vehicles in the management of Japan’s FX reserves. The purchase amount is currently undecided.
Upcoming Data:
- Wed: Canada Housing Starts
- Thu: BoE, ECB, Initial Jobless Claims, Japan Current Account
- Fri: Japan Eco Watchers Survey,
Global Macro Trading 
On SX5E, it may be worth working in the divi futures angle for some additional insight, eg compare performance of DEDZ3 with, say, DEDZ6 since October.
On Japan, I quite like this S+P note: http://www.standardandpoors.com/spf/upload/Ratings_US/JapanReflationDec2012.pdf
Thanks Vandals, for both the comment and the link. Both are very interesting.
Re: the S&P Japan comment, I agree with most of the author’s points – but I think that despite the timidity of the BoJ, it is also facing a different situation vs the US & UK. Namely, the secularly decreasing population itself acts as a massive deflationary driver. With demand for domestic products guaranteed to shrink YoY, I think most Japanese merchants will find it very hard to justify increasing prices every year. Even if QE can change inflation expectations over the short term, I don’t think it can over the long term … barring a Weimar Republic scenario.
It is also worthwhile to note that the effectiveness of QE wanes over time. With the US, UK and Japanese central banks already owners of a large portion of the outstanding debt stock, even a doubling of balance sheets may not have a large effect – while also reduces the effectiveness of future QE. Yes, the BoJ has not been aggressive enough – but it has moved timidly for a much longer period of time.
Finally, the S&P author makes a good point on the duration of JGB’s the BOJ has purchased. But there we run into the zero bound problem… If the BoJ purchases a massive amt of JGB’s, it will drive 10y yields to what? 50bps? 25bps? At 25bps, many Japanese financial companies will probably be unprofitable.
Re: SX5E dividend futures – thanks for bringing that up. 2015 futures have certainly outperformed substantially since 3Q. That all makes sense, but my point in the post is – how long can the index trade at these valuations if the earnings don’t come through? Maybe Japan is a good example – in that case, seems like stocks basically fluctuate around a high P/E level until there is an exogenous shock.
Also interesting is the rolling 2nd/3rd futures spread. The peak there in late 2009 was +2.4, and it is trading at -2.3 now. Maybe that is the setup for an interesting asymmetric trade down the line…
I broadly agree with all of your points. On SX5E, despite the recent rally, the terminal level of divis still looks lowish, so I guess there’s still some scope for analysts to promise ‘jam tomorrow’. Having said that, after a long period long SX5E and divis, we are out as of last week, and happy for others to try to wring this particular chamois.
On Japan, I’m a mere dabbler, as I find the economy and mkts Through the Looking-Glass qualities disinclines me from grinding any major axes. At the moment, we’re in the phony war stage, which disinclines me even further from getting heavily involved. Having said that, it seems clear to me that enthusiasm for the short Yen thesis is being driven at least partially by (a) fear of missing the big move after all this time, (b) nothing much else going on in major FX at the moment, leading to disproportionate interest in the JPY. Hence I expect something of a pullback due to crowded positioning, and then I guess we could drift weaker until the rubber actually hits the road in Q2, when we get to see if the new boss is the same as the old boss.
cool, thanks for sharing.