The bearish case for European equities
Earnings have fallen 22 per cent in Europe in the last four years.
Dubai - The macro risks in Europe are rising
The Euro Stoxx 600 is a short at 350 as the bearish case for European equities becomes even more compelling. The British referendum on the EU has split David Cameron's cabinet and the Tories. Francois Hollande faces militant trade unions and the National Front in next April's presidential election with the lowest approval ratings of any French head of state in the Fifth Republic. Chancellor Angela Merkel's decision to let in a million refugees and sign an accord with an autocratic Turkish president has devastated voter support for her CDU and accelerated the rise of the far-right AFD. Italy's Matteo Renzi faces a voter backlash against his economic restructuring reforms. In Spain, the post-Franco two-party system has been shaken by Podemos. The far-right Norbert Hofer almost became president of Austria last week. Anti-EU political parties rule in Poland and Hungary. Russian troops occupy the Crimea and destabilise east Ukraine. The macro risks in Europe are rising.
Despite on ultra-dovish ECB and rising German union wage concessions, the risk premium in European equities continues to rise due to angst over bank losses (Deutsche Bank shares down 50 per cent since 2015 high!), negative interest rates, Brexit, Greek sovereign debt and the Spanish elections.
Sentiment and flow of data in European equities are truly scary. Equity funds have seen outflows for eight successive weeks, the longest since Lehman's failure in 2008. Investors have yanked $32 billion from European equities in 2016 alone. The cognoscenti in the Old World do not believe ECB buying of corporate bonds will remotely boost European earnings growth. Deutsche Bank downgraded European earnings growth in 2016 from a mediocre four per cent to a truly dismal two per cent.
European banks, the highest-weighted sector in the Stoxx 600 index, have been sandbagged by negative interest rates, draconian fines from Washington on Iran, Libor, product misselling, etc, are a classic value trap. While Stoxx 600 trades at a discount to the S&P index at 15.9 times earnings, this is a stratospheric valuation for an asset class where earnings growth has collapsed while macro/risk premium are set to rise. I would not be surprised to see the Euro Stoxx 600 fall to 280 in the next six months as the financial markets are unnerved by Fed rate hikes and geopolitical black swans.
With the German Bund yield at 0.28, the lowest borrowing rate since the Treaty of Westphalia almost four centuries ago, the only economy that has truly benefited from the oil fall, euro plunge and rising capex is Germany, one-third of eurozone GDP. Yet German large cap exporters and the Grossbanken are hugely exposed to the big chill in world trade due to the economic slump in China.
It is essential to pick the right strategies and sectors in European risk assets in 2016. For instance, German real estate companies will benefit from a refinancing wave and the fall in debt service costs. Insurers Axa (France), Allianz (Germany) and Aegon (Holland) benefit from a steeper US Treasury yield curve as the Fed rhetoric turns hawkish ahead of the June FOMC. Switzerland's Roche just announced another cancer drug breakthrough. A fall in borrowing costs will also stimulate stock buybacks, higher dividend payouts and merger bid, as in Wall Street since 2012. There are stellar growth plays in small cap European software/Internet shares.
Earnings have fallen 22 per cent in Europe in the last four years and I see no catalyst for an uptrend in 2016. Multiple macro risks inhibit capex and consumer "animal spirits". Most European corporates are far too conservative and uptight to even consider taking advantage of epic low interest rates to leverage their balance sheets and boost US style buybacks to goose valuations. Wolfgang Schäuble is the Herbert Hoover of Europe in his refusal to sanction fiscal stimulus in a time of deflation.
With sterling at 1.47, I see no Brexit shock but Trump and Clinton have both attacked the global free trade regime, a dark omen for the EU. I sense fear as I talk to friends who manage money in Paris, Lugano, Bishopsgate and the Rue de Rhone in Geneva. Why else do European equities fund managers keep 5.6 per cent of assets in cash, the highest since 2001? Europe has caught the "Japanese disease" and faces its own lost decade of deflation. I remember the Nikkei Dow's lost decades all too well, when the index sank from 39,000 in 1990 to 8,000 in 2012. Only a fool bets against history.