EUROPEAN BASKET CASE
2016-05-04 1pm EDT | #ECB #Europe #Eurostoxx #Draghi
Yesterday there were some renewed fears about European banks that weighed on stocks throughout the world. European stocks were especially heavy, and US stocks didn’t even try to rally until Europe closed.
Most investors believe Europe to be an uninvestable basket case, but I am not as pessimistic. The move to negative rates has hurt confidence in Europe and convinced market participants the ECB has become powerless.
Although I understand this worry, in typical fashion the market is not giving current policies enough time to work. But before we go through the bull argument, let’s have a look at how we got here.
Eurostoxx / S&P 500 ratio through the years
We all know European stocks have been lagging US equities for the past year, but what does this ratio look like on a little longer time frame?
For the past 5 years, it has been a steady drip lower. I guess that makes sense given Europe was slow to engage in aggressive monetary expansion in the wake of the 2008 credit crisis. Europe was constantly trying to take back the stimulus while Bernanke kept the throttle down hard. Remember all the austerity talk? And let’s not forget Jean Claude’s “inflation is coming” 2011 double hike…
Given the disastrous overly tight monetary policy, it is no surprise the Eurostoxx dramatically underperformed US stocks during this period.
But surely the previous 5 years before that was more up and down. Let’s look at the ratio for the past 10 years.
Holy crap. Same story. Relentless drip lower. Did European stocks ever lead?
We have to go back almost 20 years to find a time when European stocks outperformed their US counterparts.
1999 was the only year where European stocks significantly outpaced the S&P 500. That seemed like a strange time for Europe to outperform as the US was in the midst of a massive DotCom bubble. I understand the bubble was centered in technology stocks and that ordinary US stocks lagged, but this still seems counter intuitive.
But then I realized this was the period when the Euro was introduced. The Euro currency came into being January 1st, 1999. For the next year European stocks exploded higher versus the US. This optimism regarding the great European monetary union proved to be the absolute top. Since then European stock markets have lost value in relation to the US.
Although all the academics will happily spout on about the wonders of the European Union, I am not so sure about its efficacy. Surrendering your monetary independence seems like a terrible policy. I distinctly remember in 2002 when the Canadian economy was a complete basket case Sherry Cooper, an influential economist with the Bank of Montreal, made the case Canada should tie to the US dollar at 1.60 before the currency goes to 2.00. The amazing part is five years later after she was proved spectacularly wrong, she made the case we should peg it to par. F’ me. Really?
Allowing our currency to float up and down is a vitally important stabilizer as economic conditions change. These academics who want to give up this independence are trading short term minor theoretical efficiencies at the expense of long term flexibility. Canada’s monetary policy needed to be dramatically different in the commodity boom of the last decade. Why on earth would we have allowed another country to set monetary policy during this unique time?
The ECB tries to set the best rate for the union as a whole, but it just ends up being a bad rate for everyone. In the process, real growth sucks wind. Have a look at this chart of real GDP growth since the 2008 credit crisis.
It’s no wonder European stocks are performing so terribly. The actual amount of real wealth being created is lagging the US dramatically.
When Bernanke introduced his 2nd and 3rd QE programs there were plenty of skeptics who claimed he was pushing on a string. You may argue it will all end in disaster, but that attitude didn’t help as stocks rocketed higher. As traders our job is not to figure out what should happen, but what will happen.
The current ECB quantitative easing program is every bit as overwhelming as Bernanke’s program.
The constant bickering about monetary policy amongst EU members has certainly lessened QE’s effect, but if the Central Bank keeps buying assets, eventually it kicks in. Many market pundits believe Central Banks have hit the wall where their policies have no effect. Although I will concede it becomes increasingly more difficult as more and more debt keeps piling on, I don’t buy the idea Central Banks cannot effect asset prices.
These same arguments sprung up with Bernanke’s QE2 and QE3. Yet as Bernanke kept writing the blue tickets, it eventually worked.
As long as Draghi doesn’t back down, these aggressive monetary policies will kick in. Investors that are betting on Europe’s demise will find themselves cursing the ECB.
For too long the EU has engaged in policies that were akin to shooting themselves in the foot. This monetary union has created a monetary mess. The folly of having one rate for the entire European Union has created a less than optimal interest rate policy for almost every EU member.
But we have hit the tipping point where instead of trying to balance the needs of all members, Draghi has gone balls to the wall all in. This new rate is low enough for absolutely everyone.
Have a look at the Wu-Xia shadow rate for Europe:
The European shadow rate is at a stunning negative 4.5%! Even in the depths of Bernanke’s QE3 program the US only reached negative 3%. This is an unprecedented amount of monetary stimulus being applied to the European economy.
Most market pundits claim it won’t do any good. Europe is too far gone they say. Well, I disagree. I saw an article the other day about a European homeowner whose outstanding mortgage balance went down, not because he had paid some off, but because he was enjoying a negative interest rate. Even a German will have trouble not taking out a loan and buying a house in that sort of environment. Yeah, yeah, I know - the credit creation mechanism is not functioning properly because European banks are such a mess and will not lend. I get it. But so does everyone else. That pessimism is built into the price.
Where will the surprise come from? It won’t be from Europe continuing to lag. I think Europe has underperformed for 18 years and offers decent value against an over priced American market. When you combine that cheapness with an aggressive Central Bank and a general disbelief monetary policy will ever again work, I think you have the recipe for a great long trade. If you are really bearish on the US, this is a great spread trade. Or if you just want to bet outright long, then I think Europe is worth a punt.
I know few investors are bullish on Europe. The idea quantitative easing has become powerless is now consensus. It is ironic because two years ago Central Banks could do no wrong. I am not judging the “correctness” of their actions, but I do believe Central Banks can still effect prices. This sort of doubt occurred in the US during various QE programs, and it eventually resolved to the upside. I expect the same to happen in Europe.
Thanks for reading,