Inside investment: Courage, mon brave
With a socialist at the gates of the Élysée Palace and the eurozone limping along, there has never been a better time to buy cheap European equities.
Last year a piece of market lore about as hackneyed as ‘don’t fight the Fed’ or ‘buy the rumour sell the news’, would have all but guaranteed a bumper bonus, personal aggrandisement and the respect of one’s peers. If you had followed the old saw and sold equities on the first trading day of May and not gone back into the market until the Monday after the running of the St Leger Stakes on September 10, a 20% decline in the MSCI World Index would have been artfully dodged.
For those of us who laughed in the face of such unscientific nonsense, £50 on the nose of the aptly named Masked Marvel (winner, at reasonably rewarding odds of 15/2, of the 235th renewal of the world’s oldest classic horse race) was some, scant, recompense. Perhaps the lesson is that you should never look a gift cliché in the mouth. Now that rough winds shake the darling buds of May, is it time again to follow the letter of the lore?
The rally since autumn’s lows has been impressive for global equities. The advice of this column in January to dip into US equities has been rewarded with the S&P500 extending its end-of-year gains by a further 10%. Emerging markets have done equally well, with Asia outperforming. Japan and Europe have been the laggards. Europe (ex Germany) has only just eked out a positive return year-to-date.
At the start of the year the basic premise was that a lot could go wrong in the first quarter, but much of the bad news was in the price. Since then there have been positive economic surprises, particularly in the US, and a floor has been put under equity prices there. The earnings season is looking likely to prove benign.
Politics have added an additional level of risk, most immediately in Europe. The Greeks went to the polls on May 6 and France has elected only the second socialist president of the Fifth Republic. The first one, François Mitterrand, nationalized the "commanding heights" of industry, including the banks, and devalued the franc three times in his first term.
Argentine president Christina Kirchner’s action over YPF is a timely reminder that left-leaning governments can lead to left-tailed return distributions for investors. Later in the year the US goes to the polls and a new generation of leaders will emerge in China in a once-in-a-decade transition. Given the way markets have tended to careen in a bimodal fashion between risk-off and risk-on, it is tempting to take profits now and watch from the sidelines as events unfold.
But for the brave, a rotation from winners to losers and into select, high-quality, eurozone equities might provide greater performance zip. If nothing else it will guarantee a high level of engagement with markets and the news. The valuation rationale that supported many developed markets at the start of the year still applies in spades to the eurozone because of relative performance.
By almost any measure these markets are glaringly cheap in absolute terms and relative to their history. The forward price/earnings multiple is 10 times and the price/book ratio is 25% lower than its long-term average. The Bank of America Merrill Lynch fund manager survey reports that EU sovereign debt funding is regarded as the number-one tail risk and that asset allocators are adding to their European underweight.
As it became clear last year that Europe would dip back into recession in 2012, analysts moved to cut their earnings forecasts. This game of reverse trumps always goes too far. These are the perfect conditions for a rally. European equities are fundamentally cheap, they are unloved and there is nascent potential for upside earnings surprises.
But the biggest game changer of all in Europe has been new European Central Bank president Mario Draghi. Two rate cuts and rounds of Long-Term Refinancing Operations show that "Super Mario" gets it, perhaps more than any other policymaker in the world bar Ben Bernanke. Banks are liquid again and a credit crunch has been avoided. Without that change in ECB policy we might already have been writing the obituary of the euro.
The citizens of every country that slips back into recession, making debt levels unsustainable in spite of painful austerity (Spain being the latest), should curse the Bundesbank-inspired orthodoxy of Draghi’s predecessor. But each time it happens it also brings full-blown quantitative easing a step closer. That is the most compelling case for European assets. The Federal Reserve and Bank of England have already fired the ultimate policy bullet. Draghi still has his in the chamber.
A weaker euro would be good all round. It helps the struggling periphery become a little more competitive. German exporters can grow even richer. Eurozone growth would be primed for a stronger bounce-back in 2013. If you want to double up on this contrarian bet on Europe, hold your nose and buy the banks.