European Equities Can Still Outperform

We still prefer Europe within a global equity portfolio.

DIN-20150604-152713

According to our European strategists, a weakening credit impulse (discussed in the previous Insight) implies that growth will level off at around a 2% clip in Europe. For investors, this should still provide reasonable but unspectacular earnings-per-share growth.

After a 25% rally since December, European equities are no longer outright cheap. But it is hard to find mainstream investments in any major asset class anywhere in the world that are outright cheap. Today’s choice for investors is not particularly appealing, essentially a task of finding the least worst of a lot of dirty shirts.

Against this backdrop, we still prefer Europe within a global equity portfolio – especially currency unhedged. In common currency terms, European equities still have substantial catch-up potential with other major stock markets one way or another. A near-term positive catalyst would also arise if Greece concedes enough ground to its creditors to kick the can down the road for a few months.

Euro Area Corporate Fundamentals On The Mend

The Euro Area Corporate Health Monitor (CHM) moved further into ‘improving health’ territory in the fourth quarter.

DIN-20150526-230821

Our Corporate Health Monitors (CHM) for the U.S. and Euro Area are a composite of six key financial ratios for the entire non-financial corporate sector that rating agencies use when rating companies. The data required to construct the CHMs are unfortunately published with a long lag, but the Monitors have nonetheless been useful over the years in heralding trend changes in corporate spreads.

As noted in earlier Insights, the fact that the U.S. CHM is in ‘deteriorating health’ territory confirms that the U.S. credit cycle is in the late stages, although we still believe that it is too early to give up the carry in the U.S. corporate sector because real interest rates and bank lending standards have not deteriorated. Historically, signals from the CHMs have been most useful when confirmed by these other two factors. Meanwhile, the Euro Area CHM moved further into ‘improving health’ territory. Corporate fundamentals are generally moving in a positive direction for the corporate bond space in Europe, despite some early signs of froth in the high-yield sector.

That said, corporates are not trading on fundamentals at the moment; it is a QE, liquidity-driven market. The ECB will continue to shrink the stock of government bonds available to the private sector for at least the remainder of this year, forcing investors into riskier asset classes.

There is a risk that the hunt-for-yield that has driven investors beyond their “quality” comfort zone goes into reverse. If the long-end of the Bund curve were to shift up another 50-100 basis points, investors that have stretched for yield may be able to move up-in-quality and still meet their yield bogies. This shift would place upward pressure on spreads, especially in the high-yield sector.

Nonetheless, Bund yields are more likely to decline than rise. The Greece negotiations could provide some spread turbulence, but the improving economy and the aggressive ECB backstop extend the sweet spot for Eurozone corporate bonds.

The Biggest Risks For U.S. Credit

Our U.S. bond strategists have made the case to remain overweight credit until monetary conditions become excessively restrictive, which is anticipated to be at least a couple Fed rate hikes away. In the meantime, there are two non-trivial risks that could cause temporary harm to long credit positions.

DIN-20150526-221350

Last year’s dramatic collapse in the price of oil set-off a minor panic in the corporate bond market. Spreads widened significantly, and the pain was not limited to energy related credits. While fundamentally there is no reason that lower oil prices should raise questions about the creditworthiness of non-energy related firms, fund outflows are likely responsible for a good portion of the observed contagion, at least in the high-yield space.

If our commodity strategists are correct that oil prices have overshot to the upside, then oil price downside poses a major near-term risk to corporate bond spreads. To gauge the potential magnitude of this risk, we calculate the trailing 26-week beta between changes in corporate bond spreads and the price of Brent crude oil (Table above).

Assuming that the calculated betas remain unchanged and that the Brent price falls to $50 over a six month period, high-yield energy sector spreads have the greatest sensitivity to oil prices, followed by non-energy high-yield spreads, investment grade energy spreads and non-energy investment grade spreads. This exercise assumes that betas remain unchanged, which will probably prove to be an overly pessimistic assumption. In all likelihood any renewed oil price shock will not be as severe as was witnessed in 2014, and fund outflows are unlikely to be as dramatic. A strategy of avoiding energy names in both investment grade and high-yield corporate bond markets is sufficient to mitigate the potential shock from another downleg in oil prices.

Low Growth And High Debt: Financial Repression Is Here To Stay

In case we needed to be reminded, the IMF’s latest World Economic Outlook included a section on the rather dismal long-run outlook for economic growth. Trends in demographics and productivity are expected to deliver average potential growth of only 1.6% a year in the advanced economies during the remainder of the decade. Such measly growth will make it very difficult for governments to lower current high debt-to-GDP ratios.

In this Special Report, BCA’s Chief Economist, Martin Barnes, explains why debt burdens are more likely to rise than fall over the short and long run given demographic trends and the low odds of another economic boom. If governments cannot easily bring debt ratios down to more sustainable levels, then the obvious solution is to make high debt levels easier to live with. This can be done be keeping real borrowing costs down and by regulatory pressures that encourage financial institutions to hold more government securities. In other words, financial repression is the inevitable result of a world of low growth and stubbornly high debt.

Martin argues that central banks are not overt supporters of financial repression, but they certainly are enablers because they have no other options other than to keep rates depressed if they cannot meet their growth and/or inflation targets. A world of financial repression is an uncomfortable world for investors as it implies continued distortions in asset prices, and it is bound to breed excesses that ultimately will threaten financial stability.

For the full report and investment implications, please see Low Growth And High Debt: Financial Repression Is Here To Stay.

The Spike In German Bund Yields Will Not Last

The recent selloff in German bunds has been driven by two factors. First, Grexit risks have abated. Second, and more importantly, euro area growth continues to surprise on the upside.

DIN-20150508-164435

The IMF reckons that the lagged effect of a weaker euro alone should boost real GDP by a cumulative 1.7 percentage points by early next year, with lower oil prices contributing another 0.3 points. In addition, we estimate that increased government spending could boost growth by a further 0.3 points this year, while the shift from negative to modestly positive credit growth could add a full percentage point.
This is a lot of extra growth in a very short period of time, and so it is not surprising that investors have begun to reconsider their view that the ECB will keep rates on hold for many years to come. However, while the euro area economy is likely to fare well over the coming few quarters, the party will not last far into 2016. Please see the next Insight, (Part II) The Spike In German Bunds Will Not Last.