Two weeks ago the ECB launched an aggressive €1.1-trillion QE program in a bid to reverse the Eurozone’s dismal economic fortunes. Wendell Perkins, portfolio manager at Manulife Asset Management in Chicago, says the first step in analyzing the bold move is to distinguish between known and hoped-for effects of QE.
“We know QE will depreciate the currency, and it clearly is [doing so]. It will [also] keep interest rates artificially low for a period, and we certainly saw that in the U.S. and the U.K.” He adds QE should also reduce deflation risk.
Hoped-for effects: economic growth and increased demand for risky assets. He warns “it’s not a no-brainer” that European equities will get the same boost U.S. stocks got from the Fed’s QE program.
There’s a common misperception that European equities have been cheap underperformers for some time. But ever since ECB president Mario Draghi pronounced in July, 2012 that he’d do “whatever it takes” to save the continent’s single currency, the European market’s gone up about 70%, says Perkins—a slightly bigger jump than the U.S. market’s seen in the same period.
“Given where companies are priced, and the run we’ve had, […] it’s unclear whether we’re going to see the same significant stock rally [the U.S. had]. The other piece is that 70% return has happened with basically no earnings growth. It’s all been a massive multiples expansion.”
Perkins says earnings have to be a factor in market performance. “The markets expected double-digit earnings growth in 2013 and we didn’t get it; they expected [it] in 2014 and we didn’t get it. Here we are in 2015 and again the market’s expecting double-digit earnings growth. At some point earnings have to follow through.”
Where to look
Perkins notes value investors will always find cheap, under-appreciated companies no matter where we are in the economic cycle.
But Europe’s current macro situation offers specific opportunities. The weak euro benefits companies with U.S. subsidiaries, as cashing in greenbacks will boost earnings.
Healthcare, food and beverage, and consumer staples firms also stand to benefit. “Those are places in the market where we have a great deal of exposure,” notes Perkins.
He adds banks have potential, but he’s still underweight because he’s not convinced QE will give them the boost many expect. Regulatory pressures, Perkins says, are a persistent headwind: there’s concern the banks are still undercapitalized, and stiffer requirements won’t bode well for profits. “While there is a European standard on capital, individual countries can demand higher levels. So we need greater clarity on capital requirements.
“And there continues to be this overhang of misdeeds that particularly haunts the banks. For example, last fall BNP [Paribas] paid the U.S. a $10-billion fine. When you’re worried about capital levels, a $10-billion hit is significant.”
Perkins says we need to see an increase in loan demand if Europe’s banks are to become attractive. “Rates are obviously exceptionally low, but it’s not bringing about demand.”
He’s overweight the insurance industry partly because the regulatory environment isn’t as challenging. “And [the industry] is much more stable [because] demand for insurance products is stable; whereas, with banking, consumer and industrial demand are cyclical.”
Karen Ward, senior global economist at HSBC Bank, has low expectations for this round of QE. “The first and most simple reason is that quantitative easing hasn’t worked as well as hoped,” she says in a report released last week. “That’s not to say it hasn’t had any impact on growth; we don’t know the counterfactual, and it’s highly likely that […] economic activity would have been significantly weaker had they not opened the monetary spigots. But it’s also fair to say the recovery hasn’t been as robust as hoped.”
Japan’s the clearest case: going into 2014, the consensus view was upbeat for GDP growth. But as the year unfolded, the data painted a picture of an economy that couldn’t grow.
Another problem: “For politicians, quantitative easing is the perfect cloak under which to hide. They can continue telling their electorate that the hard graft and near-term cost that often comes alongside structural change is not necessary. The consequence may be economic stagnation, but for a politician that may be more desirable than widespread discontent as ‘entitlements’ are withdrawn.”
Ward says fiscal stimulus has better odds of improving the Eurozone economy. It should focus on public investment, jobs and skills.
Public investment projects should be “driven by the feedback and needs of private business since the objective is to create infrastructure that will then facilitate private activity and generate tax receipts. Public infrastructure programs that have failed in the past were often […] motivated by political interests rather than the needs of the private sector.”
European Commission surveys show firms now see skilled labour shortages as the main obstacle to production (financing was the key problem at the peak of the crisis). Ward admits “announcing a major spending program on education, training and jobseeker assistance isn’t going to lead to a quick boost to financial market sentiment in the same way as a large-scale QE program.
“But perhaps now policymakers should spend more time working on what will boost business confidence directly, rather than concentrating their efforts on boosting investor sentiment and hoping the effects will, through time, trickle down.”