Dear Valued Clients and Friends –
Welcome to the inaugural issue of Market Epicurean, our attempt at providing our deepest contribution to discussion of the investment landscape. Dividend Café will continue to be our web property that houses our weekly thinking, with a very strong commitment to delivering readable and comprehensible material each and every week. With Market Epicurean, the handcuffs will be off in terms of vocabulary and depth of concepts. I have spent the better part of twenty years studying capital markets, credit cycles, and the economics of risk premiums. In my wealth management business, my job is not to articulate the academic foundation for investment returns, but rather to work tirelessly towards creating outcomes that facilitate the needs of our clients. That effort is communicated in Dividend Café, and it is what our clients pay for. Market Epicurean, though, is for those who actually want to read a bit of the deeper dive – the more high-level material that captures our thinking and focus but is not necessarily of interest to a broad investing audience. As the name suggests, we want this property to feature our more “lavish” thinking, and of course we hope it will grow the investment knowledge and perspective of its readers. My promise is that, for right or for wrong, it will reflect my own thinking, never contradictory to what we serve up at Dividend Café, but maybe just a more “gourmet” version.
I do not plan to keep the same format of Dividend Café (with snippets of information in paragraph form after various headlines). Most often it will feature a straight column or article, often with charts. It may be posted Friday; it may be a different day some weeks. And it also may not be a regular weekly affair, whereas Dividend Café most certainly will remain such. We are really very open to your suggestions as we build this out. Content creation and thought leadership are at the very heart of what we commit to offering our clients. We believe our investment worldview is thoughtful, intentional, and subject to intense empirical scrutiny. By sharing more of this worldview with our clients, we hope to grow the investment IQ of those who have entrusted their financial outcomes to us, and we hope to add value to your financial lives at whatever level you choose to receive it.
So what to write about in this inaugural issue? The various tweets, policies, policy intentions, press conferences, and other such ruminations of the Trump administration are likely to be more appropriately digested at Dividend Café. However, the investing complexity nightmare that is Europe seems more appropriately dealt with here, and I want to make that our first Market Epicurean topic.
There exists for value-oriented portfolio managers an extraordinary dilemma when evaluating the European continent. On one hand, whether it be in relative value to other developed opportunities, or in the absolute value of the isolated opportunity set, European markets offer a compelling case for investment. Indeed, Eurozone GDP growth actually outpaced the United States in 2016, and of course the U.S. market multiple is leaps and bounds higher than that of the Eurozone.
* Strategas Research, April 28, 2017
A seemingly improved economic outlook in Europe up against wildly divergent stock market performances in recent years should argue for a compelling relative case.
And lest we forget the contrarian case, the flows U.S. investors have committed to U.S. equities vs. European equities do tell a rather powerful story. It should be noted, however, that U.S. equity investors and their highly home-biased flow tendencies over these last six years have proven prescient, at least up until this point.
* CFA Institute, Enterprising Investor, April 28, 2017
The tension for value managers comes when we consider the actual reality of the European member nation balances sheets. Of course, the debt levels of the United States do not invoke sentiments of relief, but debt-to-GDP levels in most European countries are stratospheric, with Italy’s gross government debt as a percentage of national GDP exceeding 132%, Greece’s of course exceeding 175%, Ireland exceeding 117%, Portugal exceeding 130%, Spain at 100%, and France exceeding 96%. It must be said that these percentages, horrifying as they are, come after five years of unprecedented monetary stimulus to lower such, with a comprehensive plan implemented by Mario Draghi and the European Central Bank to essentially monetize and mutualize Eurozone governmental debt. There is simply no way to speculate how high those ratios would be apart from monetary intervention, because apart from monetary intervention significant defaults would have materialized. Price discrepancy between competing market indices seems warranted when we factor in the debt/deflationary context that has overwhelmed European realities.
The bullish argument for entering European risk markets is the general value/price thesis, that price levels have overshot the realities of the debt overhang, and that economic fundamentals are now improving (helped by the equivalent of a monetary bazooka for five years). The bearish argument is that Europe has succeeded in kicking the can down the road, but not in solving for the tension of a shared currency in an economic zone that features non-shared economic needs and conditions. Additionally, the ECB is highly likely to offer forward guidance in June that they will begin tapering their quantitative easing, and they are likely to actually begin this tapering in September. In other words, even one accepts the bullish argument for value, the bearish argument that the monetary punch bowl faces being pulled away must influence one’s risk-reward calculation.
Perhaps the conclusion should be determined not by the behavior of the European Central Bank alone, and the impact of their inevitable tapering of QE, but the impact of European monetary policy when combined with the rise of populism, the overhang of massive debt, and the perpetual threat of what economists call “redenomination risk” – the idea that some countries may seek to address their debt drag by redenominating it in their own currency. In other words, perhaps the bearish thesis is right, but not right enough? Is there investible opportunity in a continent with these kinds of existential fiscal and monetary issues in front of it?
The reality is that from a trader’s perspective, should business cycles prove to be in the early phases of profit growth, there is a play in European equities to be had at present. But that trade is dependent upon Europe now entering a cycle like the U.S. entered back in 2013 or so – where monetary conditions came off and corporate earnings and economic fundamentals did the heavy lifting. Certainly the likelihood that France’s election will not represent a black swan event to European stability helps this argument, or at least removes a risk consideration in making it. We would not bet against the thesis that Europe is due for a bullish move up due to its relative valuation (though that is different than betting on it). The fundamentals are compatible with this view, at least as it pertains to corporate profit margins:
These enhanced margins point to as much as 10% earnings-per-share growth this year, whereas earnings were completely flat year-over-year just six months ago. It would, indeed, be hard to justify a P/E ratio at a 25% discount to the P/E ratio of the S&P 500 should 10% EPS growth materialize (though we should note, the long-term average discount is roughly 15%). But our view at this time is that a 10% discount in European equity markets to long-term relative valuations is justified by the political tensions there, and even more so by the long-term debt drag on real continental growth. Should that risk premium expand, we may very well change our viewpoint and pursue bottom-up European equity opportunities more aggressively.
Our analysis suggests the UK represents a better risk/reward proposition for U.S. investors looking to diversify into transatlantic investment opportunity.
We would note that the major drag on UK stocks for U.S. investors has been the declining sterling pound currency relative to the U.S. dollar. The pound has just recently passed its own 200-day moving average relative to the greenback for the first time in two years. The substantial re-pricing of the sterling in 2014 and again in 2016 has very likely bottomed, providing a currency backdrop of strength for UK equities worth considering.
The absolute level of a currency does not project value or lack of value. And technical indicators only tell us what has been, not will be. Fundamentally, we look to purchasing power in proportion to other currencies to determine currency value. Whether it be relative to the Euro or the Dollar, the sterling offers fundamental value regardless of what short term fluctuations produce.
A source of distress in UK forecasting has been fear that the Brexit would impact their trade activity negatively, but we would point out that UK imports far more from the Eurozone than it exports (meaning European exporters have more to lose from bad faith trade negotiations), and UK exports more to non-European areas than it does the Eurozone itself:
It also is an economy seeking growth in the private sector, where more sustainable and economically productive activity is likely to be found versus the governmental sectors. None of this is to suggest that a currency rebound is imminent, or that UK economic activity is without blemish. It is to state, though, that the same relative arguments exist in the UK and without the various headwinds in Europe we prefer to avoid.
If indeed the risk-premium in Europe ex-UK expands, we may find a tactical opportunity to invest. And even if the risk-premium does not expand, the present levels may prove to be profitable start levels for those allocating into European credit and equity markets. However, our long-term view is that the European currency is unsustainable, and even if the currency is made permanent by an actual fiscal union (what they lack now, and what there is absolutely no political appetite for now), that would actually represent a generational drag on growth we would consider structurally un-investible. So Europe faces either the volatility, distress, and chaos of disbanding the European currency to address the reality that as presently structured it has failed (a subject for another day), or else it faces a doubling down on unification that we believe will inevitably create more problems than it seeks to solve. Therefore, the de-coupling of UK from European distress has created an even more attractive scenario for investors, made even more tactical by the weak sterling currency at present levels.
Short term: Europe ex-UK potentially offers tactical value, but we want to see higher risk premium
Long term: Europe ex-UK faces two options, both of which create very poor risk/reward opportunities
Short and long term: UK ex-Europe is the more desirable investment option
David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Partner