Recap 2015-03-03: It’s time for Optimism for Europe

Commentary:

One of the things I remember from the dark days of 2011 and 2012 was Lloyd Blankfein’s comment that a lot of people are talking about things that could go wrong, but they shouldn’t ignore the possibility that a lot of things could go right.

With respect to Europe, pessimism has been widespread for basically 5 years now, with a small interlude in late 2010 / early 2011. Following the EU crisis, much has been written about the flaws of the Euro, the structural problems, the liquidity trap, the demographic overhangs, etc, etc. These structural issues were often listed as primary reasons why the Eurozone will never be able to grow sustainably at rates anywhere close to the US. Indeed, that is what current market pricing confirms.

There, is however, another potential explanation that is much less dependent on ‘this time it’s different’ hypothesis, and much less secular. The very simple explanation is that, for the past 3 years, European sovereign yields were simply too high relative to the nominal growth rate. The chart below illustrates that for a 3 year period, sovereign interest rates were at the most constrictive levels since the Lehman crisis, and before that, the mid 90’s. On average, sovereign yields were almost 200 basis points too high over that period:

In light of that context, it really should’ve been no surprise that EU growth has been as weak as it has been. For comparison, below is a chart of the spread between US nominal growth and 10y yields. Rather than 200bps above, US yields were close to 200bps below nominal growth.

The fact that EU yields are now roughly equal to current nominal growth rates, and well below forecasted growth rates, for the first time since 2007 should be a source of enormous optimism for Europe. In fact, it should be noted that EU data has already been picking up for quite some time now. I want to highlight a few in particular.

First, over the past year, Spanish Unemployment has been improving at the best rate since 1999:

This is a story that is broadly confirmed by surging EU consumer confidence. In fact, the trend since mid 2013 suggests that EU-wide unemployment levels could decline to 9.8% by early 2018. That was the level that coincided with the last ECB hike to 1.25%:

Relative to that possibility, the EUR swaps market is discounting a 3y rate, 3y forward of just 0.59%.

Now, extrapolating far into the future is often foolhardy. The unreliability of consensus macro forecasts is well known. But the point I want to make here is that there is a very large dichotomy between consensus expectations and the plausible distribution of outcomes. The market seems quite focused on the things can go wrong, and still quite dismissive of the things that can go right.

On a related note, a friend noted that higher EU yields would be negative for EU equities, and hence would be resisted by the ECB. That’s a reasonable point that is worth going into.

First, a large portion of the decline in EU yields has been due to the massive drop in the inflation breakeven component, with the 10 segment at just 1.25% and the 30y at 1.8%, respectively. A partial reversion to the ECB’s long term target could occur without damage to EU equities. Arguably, it would help.

Second, there is a fair bit of room for EU equities to improve earnings. Better earnings => cheaper equities, which would offset cheaper bonds. In fact, current model outputs for Eurostoxx earnings suggest that consensus estimates remain a bit low:

Third, if a move up in yields were driven by German yields, the subsequent narrowing of periphery spreads is also equity positive. Note that this is exactly what the fine print of the ECB QE program intends. The issuer limit and the small size of the German debt stock relative to GDP means that the longer the ECB maintains its QE program, the more non-German debt it will wind up buying. Ipso facto, the ECB program is insurance for not just EU sovereign yields overall, but the SPREAD between them. As a side note, that is one reason why IMO periphery tighteners remain attractive, despite the fact that potential credit losses may exceed the spread.

Notable:

• RBA kept the cash rate steady at 2.25% in March after cutting in February. The Board had declined to offer much in the way of guidance following the last cut, but have made it clear today that another easing is a reasonable chance: "it was appropriate to hold interest rates steady for the time being. Further easing of policy may be appropriate over the period ahead.” A 60% probability had been priced in for a cut.
• AU Building Approvals jumped 7.9% MoM vs -2.0% exp and -3.3% prev
• Canada 4Q GDP rose 2.4% SAAR vs 2.0% exp. The prior print was revised up to 3.2% from 2.8% prev.
• Spain – unemployment fell 13.5K people vs. the St looking for a 2.9K decline. Reuters/Bloomberg
• Japan January total cash wages rose 1.3% yoy, marking a significant increase in line with December, a period supported by winter bonuses. Contribution from special wages contracted to +0.5 pp in January from +1.1 pp in December, but basic wages rose sharply by 0.8% (December: +0.2%), contributing +0.7 pp to total cash wage growth in January. Real wages record a smaller decline on slower CPI: Real wages (nominal wages less the CPI inflation) came in at -1.5% yoy (December: -1.7%), as the extent of the decline contracted in step with the slowdown in CPI.
• Stock buybacks, which along with dividends eat up sums of money equal to almost all the Standard & Poor’s 500’s earnings, vaulted to a record in February, with chief executive officers announcing $104.3 billion in planned repurchases. That’s the most since TrimTabs Investment Research began tracking the data in 1995 and almost twice the $55 billion bought a year earlier.
• China investigates second top officer for graft – Reuters

Upcoming:

• Tue: Australia GDP, Japan Services PMI, China HSBC Services PMI
• Wed: Italy Services PMI, UK Services PMI, US ADP Employment, Markit Services PMI, ISM Non-Mfg, BoC, AU Retail Sales, Trade Balance
• Thu: BoE, ECB,
• Fri: EU 4Q GDP, US Employment
• Mon: ChinaTrade, Japan Eco Watchers Survey, Australia Business Confidence, China CPI,
• Tue: Japan Machine Tool Orders, US NFIB Survey, USDA Ag report, AU Home Loans