Michael Gentile, JHU:
American overvaluations have opened the door for European markets, whose political risks have shrouded earnings growth and prolonged monetary easing. As Le Pen’s polls falter and the Euro area exercises its Brexit leverage, the value of the Euro will improve and enhance the credit of debt-ridden lenders, who may receive bailouts regardless. And if unfulfilled presidential promises deflate the dollar, Europeans will save more cheaply and stoke investment that’s long escaped the bloc. Excess American supply and falling crude prices may also dampen inflation and prevent an expected ECB rate hike. These growth prospects have already spurred inflows into European equities, over $1 .7 in 2017; its American counterparts have received $31 billion, an emotion that’s only lost air of late.
While the S&P 500 trades at 18 times its forward earnings, the Stoxx 600 enjoys a multiple of 15. Though economic data largely warrants this spread, markets have projected Trump’s tax cuts, spending, and deregulation into existence. As such, policy setbacks have sprung lengthy sell-offs, the worst following the failure of Trump’s healthcare bill. Hesitation has even stalled the dollar, whose rise against the euro seemed long guaranteed. To justify this premium multiple going forward, the S&P will have to improve on its .2% growth in March. Profits must come less from share buybacks and cost-cutting measures, and more from the sales growth that’s driven the Stoxx’s 2.4% mark.
Draghi’s ever-dovish tone bodes well for prices going forward. Though the odds of a rate hike picked up with inflation, recent data has diminished the labor market’s part in it and, thus, its relevance. Following a drop in oil prices last month, German inflation slowed from 2.0% to 1.5%. Downward pressures may persist, as OPEC grows tired of US drillers offsetting its supply cuts; given Aramco’s upcoming IPO, a pump-and-sell strategy dwells well within imagination. Worse yet, Germany’s southern neighbors tail the 2% inflation target even further and, in recovery, have seen their exports rally due to a cheaper euro; adverse monetary action would threaten these developments. Taken together, the ECB must sustain its stimulus beyond 2017, keeping rates near zero to advance price levels and exploit lessening uncertainty.
Even without a rate hike, the Euro will appreciate as Marine Le Pen’s election becomes more unlikely and Monte Paischi’s bailout more imminent. Britain’s 50B Euro divorce package will deter further dissenters and ameliorate the short-term costs of separation. Currently priced at $1.06, the euro can hit $1.13 as these risks unwind, analysts say.
European banks typically benefit from US dollar depreciation, as the cost of converting overseas and buying T-Bonds decreases, incentivizing saving; a stronger Euro also reduces debt in real terms. As capital builds up, credit growth will expand and attract new investment, a prospect that uncertainty has precluded for years. More than ever, the EU must reclaim the value of membership through innovation and solvency.
Not only will Europe enjoy an accommodative backdrop, but economic sentiment and German manufacturing have both risen to its highest level in six years. Outlooks for Ireland and Portugal have improved and GDP growth will regain its 2% mark. If secondary markets for non-performing loans form, financial markets will absorb Britain’s lost profit share of the industry and repair their ability to refinance. Such transparency will also strike well with Chinese companies, who look to wean themselves from American dependence and diversify their banking system. Both Europe and China appear at odds with Trump’s populism and could find cooperation valuable going forward.
In his annual letter, Jamie Dimon concluded that “something is wrong” in the United States, among many other institutional investors who’ve grown weary of expensive stock prices. While the United States will likely fare better, regardless, its markets have overlooked downside in favor of the future; the Fed has also begun its path to tighten. On the other hand, European investors have clung to past stagnancy as a reason to forego what is possible. Sentiment ranges widely at the moment and will channel itself into arbitrage forces as their economic pictures converge more evidently. After all, less than a percentage point separated European and American output growth in the first quarter.
“Global investors are currently underinvested in Europe,” wrote Geoffroy Goenen of Candriam Investors Group. “It would be wise to reinvest in European equities, and to do so immediately.” Immediacy is key. The purpose of this article was relativity. Relative to what the market projects, Europe’s monetary environment and earning ability have weighed down the danger of short-term risks. Long-term risks depend on vast amounts of political restructuring, in regards to Greece and Italy and others who may follow Britain, and are not today’s subject. Today, investors have grown impatient with promises and, if value appears the same everywhere, will pour into cheap assets, closing the gaps.
While Europe’s downward probability remains quite low, the magnitudes of such downsides are not kind. The Euro area bears complete disintegration as its worst case, a reality that most other economies never fear—that would ripple throughout the world regardless. That being said, the world always takes notice of its end and cooperation at such times can prove remarkable. Dollars dropped on the floor and the Stoxx 600, however, are much more difficult to pick up.