International investors breathed a collect sigh of relief due to German Chancellor Angela Merkel’s sweeping election victory last Sunday. Her center-right Christian Democratic Union party achieved its best result in more than 20 years. Since the CDU did not get an absolute majority, it will have to seek a coalition partner, most likely the Social Democrats. A coalition with the Greens is the other much less likely option.
In her first press conference following the election, Angela Merkel insisted that “Our European policy will not change” and characterized her triumph as “a very strong vote for a united Europe.” We would agree, and we welcome Germany’s continuing leadership role in Europe. Though the need to reach agreement in order to effect a coalition government does leave some uncertainty about Germany’s future course, Ms. Merkel now has a strong hand. While she will surely continue to press for fiscal discipline and economic reforms, the need to work with a coalition partner may lead Berlin to be a bit more open to the problems still facing the Eurozone’s periphery. We hope that now Germany will also be more willing to move forward with the banking union.
The election results do largely resolve in a positive way one of the risks facing the Eurozone’s markets. But there remain other potential stumbling blocks. Greece will need another financial package. Portugal and Ireland look as if they are likely to be asking for further help. Also, Germany’s constitutional court is scheduled to rule before year’s end on the European Central Bank’s (ECB) backstopping of distressed member governments. Any negative elements of the ruling could spark a difficult debate on the future course of Eurozone assistance efforts.
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Additionally, there are concerns that financial conditions in the Eurozone may tighten despite the ECB’s forward guidance statement that it will keep interest rates at or below current levels “for an extended period.” While the Eurozone’s banks are no long tightening lending standards and may even be easing slightly, there are still fears that banks could strangle the recovery. The ECB’s president, Mario Draghi, sought to reassure markets by telling the European Parliament’s economic and monetary affairs committee that the ECB stands ready to provide more liquidity to banks if needed. He said, “We are ready to use any instrument, including another LTRO (long-term refinancing operation), if needed to maintain short-term money market rates at a level which is warranted by our assessment of inflation in the medium term.”
The moderate recovery in the Eurozone economy remains on track. The latest indication is the flash reading for September of the Markit Purchasing Manager’s Index. The composite index covering both manufacturing and services rose from 51.5 to 52.1, the highest level in 27 months. GDP growth for the Eurozone as a whole became positive in the second quarter and is projected to remain positive but slow going forward. GDP growth for 2014 may be only slightly above 1%.
Eurozone equity markets have responded strongly to the return of modest growth in the economy. According to the MSCI comprehensive indexes for national equity markets, the Eurozone equity market in aggregate has increased by 16.2% over the past three months, which is better than the 6.4% for the US, the 11.8% for the advanced markets outside North America, and the 8.1% for emerging markets. The explanation for this outperformance, despite subdued prospects for economic growth, appears to be valuation. Equity valuations suffered from the past crisis and from doubts about the future of Europe. Comparing the Stoxx Europe 600 with the US S&P 500, we see that the P/E for the Stoxx Europe 600 is still only 13.1, as compared with 14.9 for the S&P 500. The corresponding price-to-book value ratios are 1.7 versus 2.5.
The performance over the past three months of the different national equity markets within the Eurozone varied considerably. We will discuss just those markets for which at least one US-listed ETF is available. The “core” countries with the most solid economies had similar performance in the low-to-middle double figures: Germany, 12.9%; France, 15.6%; the Netherlands, 15.7%; as did the two smaller markets of Belgium, 13.9%, and Austria, 16.2%. Two other small northern markets had strong performance: Ireland, 17.1%, and remarkably, Finland, 27.7%. Unfortunately their respective ETFs have very limited liquidity.
Of the Eurozone’s larger equity markets and economies, Spain’s and Italy’s are the two that have gone through much more difficult times during the past two years. Spain’s Prime Minister Mariano Rajoy announced that Spain has emerged in late summer from two painful years of recession. It looks likely that Italy has as well. Rajoy noted that Spain still faces years of fiscal austerity and difficult adjustments. He concluded that “Spain is out of the recession but not out of crisis.” The same could be said for Italy. In large part because their valuations have been driven so low (the price-to-book values are 1.0 and 0.9), these markets have outperformed during the recovery over the past three months: Spain, 23.3%, and Italy, 21.8%.
At Cumberland we use only ETFs in our International and Global Equity Portfolios. There is at least one ETF for each of the Eurozone markets mentioned above. We use a combination of top-down fundamental analysis together with technical analysis to determine which markets to include, the country weights, and the trading decisions for our individually managed portfolios. We think the recovery in European equities has further to go, although the gains going forward may well be smaller.
Source: Cumberland Advisors
