I noted previously (3/5 to be exact) that one of the reasons I have been less bullish on EU equities over the longer run (as compared to the US) is that much of the move YTD has been due only to the excessively low EUR risk free rates. That was a factor that came into play yesterday, as both EU equities and fixed income sold off in tandem: (Eurostoxx in white, EUR 30y swap rates in orange and inverted)
A natural question following that is: why did EU equities get hit by higher yields this time, while US stocks escaped unscathed in 2013? A key reason is that Europe has a higher Equity Risk Premium than the US. A higher ERP that is entirely justified. Rather than expound on all the different potential reasons, many of which has been explored by others in the past, I’ll just list some bullet points:
- Widely different economies and one central bank means that on a per country basis, policy is never optimal. See footnote 1.
- The ECB’s mandate that ONLY encompasses the AVERAGE inflation, (which lags the economic cycle) across all the countries of the Eurozone, (which often have widely disparate data) means that the ECB is much more likely to act too late. This results in larger cyclical peaks and troughs and greater macro volatility, which typically results in higher risk premiums for longer dated, pro-cyclical assets. It is not an accident that they hiked in 2010… and eased in 2015. Both actions are likely to be categorized by historians as policy moves that were incorrect, IMO.
- The combination of the Maastricht Treaty debt limitations and the ECB’s inflation-only mandate means that both fiscal AND monetary policy ability to support growth in a timely fashion is impaired.
- Different politics, different laws and different courts of law means significant hurdles & friction for optimal capital deployment including M&A.
- The amount of EUR debt held by EU insurance companies, and the rigidity of EU laws for insurers, restricts the portfolio rebalancing channel. I.e. it limits the ability of EU investors to move away from fixed income into equities. See footnote 2.
Readers will note that one implication of the ERP differential is that monetary policy in Europe has a more limited room to be effective on equities than in the US. My view is that we are basically at that limit already. By my estimates, a +10bp rise in the long term EU discount rate, without a change in the forward earnings estimates, would result in a ~1.6% decline in the Eurostoxx index, ceteris paribus.
Speaking of EU yields, I noted on 3/16 that the German yield curve matches up pretty well to the Japanese curve in 2002-03. That analog seems to be working pretty well YTD:
Having said that, I do think that this analog will only take us so far. The ECB has backed itself into a corner of sorts, and to turn in the towel after only 3 months would probably be seen within the institution as being very damaging for its credibility. IMO, the recent volatility has been the result of a combination of heavy issuance and speculative positioning, combined with poor liquidity conditions. (Which of course itself heavily exacerbated by QE) In aggregate, the price action in Buxl looks corrective. The downward trend in yields has been ongoing for years now – it will take time for the trend to reverse. But recent price action certainly suggests that this is the beginning of the end rather than the end of the beginning.
Speaking of corrective price action, I noted back on 3/23 that the 1.15 area is a likely corrective target for EUR. I think that is still the case. In fact, note that without an actual Fed hike, there are no obvious catalysts that are likely to push EURUSD to new lows. As a result, we should not be surprised to see the cross range bound over the next couple quarters.
1) Disparities in EU unemployment:
From JPM Private Bank:
2) Composition of EUR debt investors from Citi: