Recap 2015-04-30: ERP in the EU vs the US

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.

Footnotes:

1) Disparities in EU unemployment:

http://www.ritholtz.com/blog/2015/04/ecb-labour-market-adjustments-in-europe-and-the-us-how-different/

From JPM Private Bank:

2) Composition of EUR debt investors from Citi:

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5 thoughts on “Recap 2015-04-30: ERP in the EU vs the US

  1. Hi GMac; I’m having trouble following the argument here. Maybe I’m not joining the dots, or there are some crucial assumptions left behind the scenes.

    I’ll accept the a priori higher ERP in Euroland argument. However, I don’t see how the conclusion follows from this, or in fact how this assumption contributes at all. I agree that European equities has largely just been a big rates / FX trade this year, with increased focus on equities as a duration substitute for investors stupefied by ultra-low long-dated forwards. So one would expect an increased sensitivity to r. However, wouldn’t this be true for any level of ERP (either outright or relative to the US). If the ERP was comparable to the US, or God forbid, tighter, it would seem to hold equally; it’s more an argument about the absolute level of rates increasing the delta of equities to rates.

    In fact, you argue that:
    “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”
    which suggests that equities should be less responsive to rate moves, which in fact is what you were suggesting on March 5th. But this seems to cut against the thrust of your argument, which is justifying why Euro equites have been whacked by the yield back-up, while US equities proved less sensitive in 2013. Surely you’re not arguing that there’s a weird delta function whereby any move down from here in rates is met by equity indifference, while any small back-up sees equities whacked? That strikes me as too much of a just-so story.

    I guess since you’ve built up this argument across multiple posts, I’m not following a few linkages that are clear to you, or perhaps I’m just being thick (which of course is not to be excluded), but this all seems rather unclear to me.

    1. That’s a very considerate and thoughtful comment! You are certainly not being thick by any means. Indeed I spent a while crafting the words to that sentence to try to be more clear. In reading it again, it seems I didn’t succeed! So I’ll try again.

      The idea is that since risk free eu rates are already near the zero (apparent) bound, there isn’t much room for additional price gains due solely to lower yields. You are right that this is not a function of the erp, I should not have lumped them together in this way. Having said that, given that does appear to be more limited room for the ecb to ease further, the range of effects of ecb policy to support eu equities here does seem skewed to the downside. That itself may be an agreement for a higher erp near the zero bound on long term discount rates.
      I’m not sure if I’ve addressed your points there, or maybe I have a hole in my hypothesis somewhere

  2. Thanks for your reply.

    Not sure I agree with this bit:
    “The idea is that since risk free eu rates are already near the zero (apparent) bound, there isn’t much room for additional price gains due solely to lower yields…the range of effects of ecb policy to support eu equities here does seem skewed to the downside. That itself may be an agreement for a higher erp near the zero bound on long term discount rates.”

    because for me, this is just as much an argument against bonds as against equities, so doesn’t, to my mind, prima facie argue for a pressure towards widening in the ERP at these levels.

    If anything, I think it’s the other way round: rates plunging to historic levels and/or remaining low for a prolonged period puts the ERP into focus for more market participants, who are forced to consider equities as a duration alternative. Every discussion you have with real money revolves around the stark choices with yields in the basement. An off-the-cuff observation is that few people were talking about ERP when rates were bobbing around 4-5%, but below 2%, suddenly it’s in sharp focus. So rates in crazyland makes equities more sensitive than ever to rates, which dovetails with the recent selloff. Yes, ERP has widened because bonds have made the first move, but now the asset allocation decision becomes quite stark – looking forward, I see a tight correlation with rates and pressure towards ERP tightening).

    Broadly speaking, when we look at bog-standard 20 PE stocks, which no-one considers exceptional these days, the most compelling argument for them comes from the discount rate. Hence, I think there’s a heck of a lot of duration risk in this equity market, perhaps more than ever, and I think, broadly underappreciated.

    I guess a lot depends on how much weight to put on the Japanese experience, which you cited in a prior post – I guess it’s an invidious choice between ‘just one data point’ and ‘what else you got?’.

    Fun times…

  3. Good points! Yes, a tightening in the ERP is certainly quite possibile if financial repression extends. I suppose a -100bp depo rate could make that happen. But my personal view is that if/when financial repression increases via yields or duration, the escape valve for EUR bond holders may increasingly be foreign assets rather than EUR equities. In other words, I agree with you that the low yields are an argument against both EUR bonds as well as equities.

    The main problem with selling EUR bonds to buy EUR equities is that, as you noted, there is a huge amount of duration risk in equities as well. If people still think that eventually yields will revert to somewhere near where nominal GDP is, buying equities does not avoid that risk. Only if the market fully believes that financial repression will be here ‘forever’ will that switch make sense, IMO.

    I think I should have made clear what my my point was all along: over the long term horizon, Dollar assets are likely to outperform Euro assets, even in local terms.

    Your point on the Japanese experience is also well made. TBH, I am not sure how much weight to put on the longer term ramifications due to the unique (for now) situation it’s in. Having said that, it seems that given the ~500bp ERP there, (depending on how you measure it) the precedent is that the locals prefer foreign bonds over local equities. Whether that is the right choice is obviously a different question altogether.

    On a tangent, High quality Fixed Income prices have been strongly negatively correlated to equities for a long time now; perhaps that correlation is in the process of turning. I did a post a while back about likely lower risk-adjusted returns for risk-parity strategies going forward – I think the price action in Europe the last week is another bit of evidence for that.

  4. All good points, though I guess you meant ‘positively correlated’ in the last paragraph if we’re talking about all but the shortest timeframes. Agree that risk parity is overdue for a shake-out; the trend has been spectacular ito risk adjusted returns (Sharpe et al off the scale), and such moves don’t tend to end on a permanently high plateau. Nothing more scientific than gut feeling and a couple of decades round the block, but such inputs have their uses.

    Re the bond / equity nexus, I guess it’s a question of timeframes: I can see equities strengthening on the ‘otherwise we may as well shut up shop rationale’ for a while, but ultimately, as you suggest, investing at gunpoint pretty much never generates decent returns, and equity holders are liable to get smoked on any bond back-up.

    My angle on all this is slightly different, as I’m more focused on the potential for European earnings growth to exceed forecasts. We’ve got the perfect confluence of factors for a meaningful and durable earnings rally in Europe, but most prognosticators seem relatively downbeat, which I ascribe largely to rear-view mirror driving. I could expound on this at length, but it’s not my blog, so I’ll treat it as axiomatic for my purposes. In such a scenario, I like equities while hedging out my duration risk, and I’m not too concerned that they’ll both be swept down the pan if my earnings outlook comes to fruition. Have to put up with some grim P+L days though.

    Re US vs Europe, I think the ultimate long term trade is the monster box: long US 30yr vs Europe; long European equities vs US. Too gut-wrenching for a trading horizon, but I really like this as a five-year view, predicated on my views on Euro earnings (and to a lesser extent US).

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