It is important for investors to reflect upon Europe’s economic predicament because the total size of the Eurozone economy approximates that of the US. Further, it has been the continual downgrading of Europe’s growth outlook that has led both the IMF and the World Bank to downgrade their estimates of world growth.
On sober reflection, it seems clear that the lift in European equity markets from 2012 had very little to do with underlying economic performance or company profit growth. Rather, it appears to be the function of low interest rate settings and the effective underwriting by the European Central Bank (ECB) of the bond market that has led to the expansion of PER multiples. Indeed, there has been so little growth and so little recovery occurring in Europe that the ECB has had little choice but to maintain extraordinary monetary support. This support is essential for both the highly indebted governments and the financial system.
Europe’s economic decline recorded in 2009 has been barely recouped in the 5 subsequent years. The overall GDP, adjusted for inflation, is barely larger today than it was in 2008. Indeed the economies of Italy, Spain, Portugal and Greece are actually smaller than they were some 6 years ago.
It is also important to emphasise the extraordinary and relentless rally in German bonds. Today the German ten year bond yield is just 1.05%; five year bonds yield 0.5% and two year bonds yield nothing! Yes, that is correct – nothing. In recent weeks, as equity markets tumbled and Russia assembled troops on the Ukrainian border, two year bond yields actually drifted into negative return territory. Such a yield would normally indicate a depression, but we know that it is the ECB’s actions that is causing this market phenomenon.
Zero returning bonds and their extension in maturity profile out to two years is an alarming development for the German bond market. It is frankly difficult to comprehend or explain and thus many commentators simply ignore its existence. The result of low bond yields and therefore the “risk free rate” of return is that other asset classes start to appear mispriced and indifferent to risk. Perhaps that explains why the German share market lurched to an historic high in June.
The German economy is the largest and strongest in the Eurozone and therefore its bonds are the most highly rated. In some respects, it is German bonds that will attract desperate euro capital in times of risk mitigation – much like US bonds and currency did at the height of the GFC. Further, German bonds are the benchmark from which other Euro bonds are priced. Euro bonds are thus often quoted at a risk margin above German bonds.
The next chart shows that risk margins of sub-prime Euro bonds have declined rapidly since mid-2013. A year ago, Spain and Italy had the same cost of
The next chart shows that risk margins of sub-prime Euro bonds have declined rapidly since mid-2013. A year ago, Spain and Italy had the same cost of government borrowing as Australia. Today, they can borrow at 1% less than Australia. Our AAA rating counts for nothing compared with the underwriting of Eurozone sub-prime bonds by the ECB.
Figure. Ten year Government Bond Yields (%)
Source. Capital Economics – European Chart Book, August 2014
The fear of deflation remains an issue across the Eurozone and to some degree this is correctly reflected in the historic low bond yields. The combination of stagnant economies, high government debt, unemployment and minimal inflation heightens the risk of a prolonged deflationary cycle. Indeed, Europe displays many of the same economic indicators that marked the Japanese economic decline over the last 15 years.
One saving grace for the Eurozone has been the improving trade account. The Eurozone is not increasing external debt owed to the rest of the world and the Euro trade zone remains a viable economic block. To a significant extent, this reflects the manufacturing muscle of Germany as it retains its high quality manufacturing status. However, it also reflects the enduring effects of economic recession in Southern Europe with its declining real wages and the resultant decline in demand for imports.
Many of Europe’s issues seem to be simply glossed over by economic and investment commentators. Whilst Europe may not be a significant trade partner of Australia, its financial markets impacts upon Australia, particularly through its provision of wholesale debt funding to our banks. Europe has a major impact on world economic growth and its recovery is needed to stabilise developed economies and create “non-Asian centric” demand into commodity markets.
We see three potential economic scenarios that could play out in Europe. These scenarios will have different impacts on the Australian economy and our financial markets. The first scenario is that Europe somehow drags itself into a normal sustained recovery. We regard the likelihood of this occurring in the next few years as remote. There is simply not enough confidence across Europe and the recovery rate, some six years after the GFC, is the one of the weakest on record. This recovery is anything but normal.
The second scenario is that Europe succumbs to a deflationary cycle (like Japan) that lasts a decade or more. Unfortunately the key financial indicators, particularly bond yields and the lack of credit demand, suggest that this is a real possibility. This scenario suggests that bond yields stay low for years and that equity markets decay due to anaemic profit growth. This scenario becomes more likely because Europe has an ageing demographic and natural population growth is slowing.
The third scenario is a blowout financial bubble that erupts following years of cheap credit and the introduction of too much liquidity into the financial system. Normally this would be quickly snuffed out by an inflation surge. However, this is not evident today and it is financial assets that are rising to inflated levels rather than consumer prices. A blowout could occur for no other reason than the rapidly spread perception that market prices have run too high against fair value. Buyers become sellers en mass and the market turns. To some extent this is playing out across world equity markets that have gyrated over the last twelve months at elevated levels. But it is the bond market that remains the true bellwether for investors. Keep an eye on European bonds, for it will be the movement in yields that will forewarn of either market calamity or economic recovery.
NOTE: This article above is for information only purposes. This does not reflect Elixir Private Wealth’s views and should not be construed as advice.