Current uncertainty in Germany, after a breakdown in talks to form a coalition government, has raised the levels of political risk in Europe and left its most powerful nation looking rudderless.
By contrast, the more orderly decision by the European Central Bank (ECB) in October to reduce quantitative easing (QE) provides certainty to European equity investors about the ECB’s direction of travel. James Ross, co-manager of the Henderson Horizon Pan European Equity fund, said: ‘The ECB’s reduction in QE surprised no one: it was well signalled. Central banks in the past decade have honed their signalling to a new degree, which helps with gauging market reaction.’ It is enough to turn Angela Merkel, if you will excuse the pun, ‘green’ with envy.
Steady as she goes
In specific terms, monthly ECB bond purchases will in January fall from €60 billion (£53.3 billion) to €30 billion, but monetary stimulus will extend to at least September 2018. ‘But another thing made very clear is interest rates will stay low for an extended period of time beyond the QE programme,’ Ross added. ‘This will temper any reaction to the tapering of QE.’
So what, then, is the impact of the ECB’s decision on European equity markets? Well, the comment of Thorsten Paarmann, Citywire + rated manager of three Invesco Perpetual European equity funds, bears out Ross’s claim. ‘From our perspective in the quantitative equities team, this is not a big news item,’ he said: ‘it is as expected.’
Paarmann added we still have an expansionary ECB policy. ‘They have taken the first steps to normalise and moderate the expansive buying programme and expansionary monetary policy,’ he said. ‘But they made clear they are looking primarily for inflation to pick up again before raising rates.’
But Paarmann does not expect a significant uptick in eurozone inflation. As such, he thinks we will continue to have supportive conditions in Europe for the next two or three years.
Ross said in 2015 and 2016 the amount of long-term government debt bought by QE exceeded the issuance. ‘This largely explains why 10-year German bund yields are lower than they should be,’ he added.
But the reduction in QE means the ECB will probably buy less than the government’s issue in 2018. For Ross, this suggests a ‘partial return’ to a more normal interest rate environment.
He said: ‘The bund yield’s direction is exceptionally well correlated to the relative performance of the financial sector, especially the banks. They have higher net interest margins when yields rise.’
So Ross expects European financials equities to outperform. He added: ‘The other side of the coin is we would expect more “deflationary” sectors that benefit from low rates, such as consumer staples, to underperform in that environment.’
Note of caution
Meanwhile, Stephen Macklow-Smith, Citywire A-rated manager of three JP Morgan European funds, said he is avoiding defensive consumer staples stocks. ‘These are bond proxies that benefited enormously in the past seven or eight years from a low interest rate environment. But bond yields are moving up again and this is not an environment in which they would necessarily thrive, although this isn’t just about QE unwinding.’
In addition, Phil Cliff, Citywire + rated manager of M&G European and dividend funds, pointed out the normalised price-to-earnings ratio for the MSCI Europe index, at 15.9, is in line with the long-run median. Similarly, the MSCI Europe dividend yield, of 3.3%, is broadly in line with the long-run median of 3.6%.
‘So equity valuations in Europe are pretty similar to the period before QE,’ said Cliff. Perhaps, then, investors in European equities need to hold tight for the long term. And the same might be said for the political parties in Germany.