ISQ - January 2022
Key Takeaways
European equities trade at a lower valuation multiple than do the US, but a discount seems warranted.
By its actions, the European Central Bank’s (ECB)monetary policy settings have evolved to an extent that reduces the pressure for urgent structural reform.
Persistent negative rates, liquidity injections and government spending have delivered little obvious multiplier effect on the real economy.
The phased introduction of Basel 4 banking regulations from Jan 2023 will likely hamper the extension of the credit necessary to support the delivery of medium term growth forecasts.
European stock markets have started 2022 very positively. At first glance, this looks to be good news and perhaps an early vindication of the fact that regional bourses trade at an attractive valuation discount to their US counterparts.
On a “through the cycle” price/earnings ratio and taking account of anticipated future corporate earnings, European equities trade on a multiple of 15x against an equivalent of 23x, but it hardly tells the whole story. Yes, European equity benchmarks are characterised by significantly greater cyclicality than the U.S. and should, perhaps, perform well were regional economic activity to strengthen. The latter’s equity benchmarks were driven by a small handful of mega-cap tech names over 2021 whilst some 60% of index constituents currently linger below their 200-day moving average. Perhaps 2022 will be the year in which this valuation divergence diminishes?
“The European Commission’s outlook for this year, published in mid-November, certainly paints a rosy picture.”
The European Commission’s outlook for this year, published in mid-November, certainly paints a rosy picture. Then again, there are good reasons why the single currency bloc should trade at a discount to the U.S.
The Commission’s projections admit that the Eurozone faces mounting headwinds; the Coronavirus pandemic is still with us and case numbers are spiking (albeit that hospitalisations and fatalities remain subdued relative to those of the recent past), while inflationary pressures are persistent and becoming less transitory and more entrenched with every day that passes. The official response to the former has been profoundly varied (Sweden versus Austria for example) and in relation to the latter, non-existent. The European Central Bank (ECB) first announced a tapering of its Pandemic Emergency Purchase Programme (PEPP) on 9 September 2021. On the face of it, this seems sensible, but in reality, all it represents is an adjustment to a lower net supply of bonds from sovereign issuers. Whilst the PEPP programme is scheduled to conclude this year, the underlying Asset Purchase Programme will continue to acquire 100% of all net sovereign issuance going forward.
By so doing the ECB is, perhaps unwillingly, acknowledging that no real secondary market exists for the region’s sovereign debt at yields driven down by years of quantitative easing. Most investors would likely prefer to accept twice, or even three times, prevailing yields given the region’s deep-seated and persistent structural uncertainties.
Indeed, the ECB has effectively admitted that, by its actions, monetary policy has morphed from being a tool to support the implementation of much needed structural reforms, to a tool that actively avoids them! Even allowing for the robust economic rebound both the Commission and the central bank forecast for this year, few regional governments are willing to reduce spending and curb elevated deficits in any meaningful way. The ECB’s own estimates confirm that following massive deficit spending in 2020, governmental fiscal largess will have risen again, by 3.4% when data for 2021 is released, and to fall only slightly, by 1.2% in 2022.
“…regional government spending will consolidate the COVID pandemic increase, with very little in the way of improvement in the fiscal position of most countries.”
What this means is that regional government spending will consolidate the COVID pandemic increase, with very little in the way of improvement in the fiscal position of most countries. In fact, countries such as Italy and Spain have actually seen their structural deficits increase.
What is entirely apparent is that persistent negative rates and equally persistent liquidity injections, combined with relentless government spending, have delivered no obvious multiplier effect. It is worth reminding ourselves that the region’s major economies were stagnating even before the onset of the pandemic and despite the Juncker Plan which drove hundreds of billions of euros in investment. Worse still, despite ECB Governing Council member, Mr Klaas Knot’s recent observation that the central bank is “on track to end bond purchases completely by end-2022, following which the policy rate can go up”, the majority of senior policymakers acknowledge that the central bank is effectively trapped by its own policy. Any attempts to normalise over and above that already announced would likely have a significant adverse impact on the region’s bond markets and in consequence, deeply indebted governments would suffer the impact of a sharp increase in borrowing costs. Yet on the other side of the coin, it cannot maintain the current pace of monetary support because inflation is imparting significantly adverse pressure on the growth outlook.
“The broader challenge for both regional governments and the central bank is that the prevailing policy setting…”
The broader challenge for both regional governments and the central bank is that the prevailing policy setting, whilst appropriate to address the worst of the impact from the pandemic, completely ignores demographic and other structural impediments to long-term sustainable growth. The region has an ageing population, a fact which the prevailing monetary and fiscal policy setting overlooks, ignoring the evidence of altered consumption patterns when citizens reach retirement age. To add to this the demographic challenge, the fact that the region’s taxation system routinely hampers the middle classes, businesses and investment, the inescapable conclusion is that the policy-setting looks eerily similar to that implemented by Japan in the early 1990s.
And so, inevitably and inexorably, to TARGET 2. Under the guise of “whatever it takes”, Dr Mario Draghi, the former president of the ECB, swept all regional bad debts under the convenient cover of the regional banking settlement system.
“By this subterfuge have still aggressively leveraged regional banks been prevented from failing…”
By this subterfuge have still aggressively leveraged regional banks been prevented from failing. Officially at least, no problem exists. This is because the ECB and all national central bank TARGET 2 positions net out to zero. To its designers, a systemic failure of TARGET 2 is inconceivable, but beneath the surface, some national central banks have mounting liabilities. The regional central bank bearing the greatest burden is the German Bun-desbank, now lending well in excess of a trillion euros through TARGET 2 to those other regional central banks seen to be exploiting the system. The mounting risk of rapidly accelerating losses, due in large part to COVID-related lockdowns, is a clear and present danger.
“The new Bundesbank President, Herr Joachim Nagel, may have been brought in to address soaring inflationary pressures, but in reality, he has a much bigger headache to deal with.”
The new Bundesbank President, Herr Joachim Nagel, may have been brought in to address soaring inflationary pressures, but in reality, he has a much bigger headache to deal with. What might precipitate a crisis is the likely phased introduction of the delayed suite of Basel 4 regulations from January 2023. Banking sector compliance, to ensure resilience, will likely involve reducing risk-weighted assets. With more than half an eye on these impending rule changes, the regional banking sector seems unlikely to provide the general expansion of credit required to support the Commission (and ECB’s) optimistic growth forecasts.
This analysis conclusion is that the Eurozone is facing a crisis that may, ultimately, call into question its very existence. Importantly, the crisis outlined above, differs significantly from that potentially facing the United States. The latter’s issues derive, essentially, from the consequences of excessive money printing. Whilst similar policies have been pursued in the Eurozone, problems are more structurally deep-seated.
“The cumulative effect of an over-leveraged banking system and a settlement system devoted to the concealment of bad debts is that the region’s economies have become progressively less efficient.”
The cumulative effect of an over-leveraged banking system and a settlement system devoted to the concealment of bad debts is that the region’s economies have become progressively less efficient. The advent of Basel 4, unless it is postponed again, could prove the trigger for a take-down of the region’s banks, its central banking network and even the euro itself, ultimately the glue that holds the entire project together.
Whilst 2022 will surely throw up some specific opportunities, both at the sector and individual stock level, in the round the region’s persistent equity market discount to the United States appears entirely warranted and its bond markets supported by a programme which may have but a limited shelf-life.
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