HEADLINE: Europe mispriced
STANDFIRST:The greatest trades are those that take advantage of mispriced assets and illiquidity. As we head into 2017’s second quarter, it increasingly appears as if the European instability narrative may be overblown as the continent prepares to outperform a shaky, “Trump trade”-dependent US.
PULL QUOTES:“Marine Le Pen as the next French president is not impossible, but what is almost impossible is Le Pen both winning and calling a referendum on France leaving the euro.”
“Precisely no one thinks that this momentum surge in equities based on hope, low yields, and the deductibility of interest on debt for corporates will end any time soon”
BANNER QUOTE: “Europe will outperform the US”
It is an old investor truth that profit is best found in mispriced assets and illiquidity. The more wrongly priced the asset, the higher the expected return
It’s similar with liquidity: more liquidity equals less expected profit.
George Soros expanded on this theme in his general theory of reflexivity, stating that:
“Usually in far-from-equilibrium situations the divergence between perceptions and reality leads to a climax which sets in motion a positive feedback process in the opposite direction”
We at Saxo Bank think this is precisely the situation in Europe. The gap between perception and reality is very wide, and this sets up attractive trades and narratives: long EUR, cyclical stocks, and general growth for the region.
European assets, except German fixed income, presently carry a small or large discount based on nervousness about the French and German elections and the end result of the UK’s Brexit.
Some of these concerns are valid; others are valid but overpriced. Most, however, are based on fear alone as we see the European economy outperforming the US over the cause of the next four years.
What non-Europeans often fail to add to their assessment is the massive amount of political capital invested in Europe and the euro. Don’t forget that Europe’s politicians are still far more in favour of Europe than its voters. In the words of European Commission president Jean-Claude Juncker (from his 2015 state of the union speech):
“There is not enough Europe in this Union. And there is not enough union in this Union”
Such sentiments aside, of course, Europe is clearly facing a near-existential crisis. But what is the worst-case scenario?
Marine Le Pen as the next French president is not impossible, but what is almost impossible is Le Pen both winning and calling a referendum on France leaving the euro. Why is this so unlikely? As the Financial Times’ Michael Stothard says:
“Under Article 89, any constitutional change needs to be proposed by the government, not the President. Then it has be approved by both the upper and lower houses and then either by public vote in a referendum or by majority of 60 per cent of the Congress. This means that, if she wanted to call a referendum, a president Le Pen would need a majority in the June legislative elections”
Hence there is little to no chance of France leaving the euro, but the market is nonetheless maintaining a “wait-and-see” attitude to this particular fragment of instability. There is also the fact that Le Pen’s primary rival, En Marche! Leader Emmanuel Macron, is a bit of an unknown quantity himself…
The biggest risk remains a new influx of immigrants; as the Dutch election taught us, support for populist parties is positively correlated with immigration levels. It’s not a pleasant truth, but it is a fact, thus the risk surrounding both a political upset and confirmation of a negative European outlook if Erdogan’s Turkey decides to reopen its borders to EU-bound migrants.
The chances of such an outcome must be calculated at 50/50 for now, and if this prior to either the French or German election, it will quickly become a major factor.
Once the elections are done in Q3, we expect a significant move in the euro’s value. Europe runs a big current account surplus, the ECB is moving towards a less accommodative monetary policy stance (and is even considering tapering), and Central and Eastern Europe continues to outperform with average growth levels above 3%.
Yes, Eurozone internal devaluation is working. Countries that are not able to devalue in their own right must instead rein in spending and wages. Europe will do better than the US in Q2, but our main global macro outlook still maintains that recession is more likely than not in the near future (12-18 months) based on the global credit pulse having peaked simultaneously with global inflation.
The biggest perception-versus-reality gap remains this risk of recession. While the market at large sees less than a 10% chance of recession, we at Saxo –together with our friends at South Africa’s Nedbank – see more than a 60% chance.
No, we are not “predicting a recession”, but our economic model does indicate a significant slowdown as the large credit impulse from China and Europe seen in the early part of 2016 has not reversed to negative, which should make the market conservative and risk averse (and certainly long US fixed income).
Along with Q2, spring is now upon us, so we will enjoy both the season and the “fake” economic spring we see now as a slowdown is coming. In this slowdown, Europe will do better than the US, EUR will do better than USD, and Asia will be under pressure to reform its way away from debt as the main driver of growth.
This leaves us with no option but to warn that Q2 and Q3 might be very different to the Trump-mania and unrealistic valuations we see right now.
I write this from Zurich Airport before boarding for Hong Kong. I have met 30 clients over the last four weeks. All 30 are overweight equities, and all 30 believe more upside is coming.
In other words, precisely no one thinks that this momentum surge in equities based on hope, low yields, and the deductibility of interest on debt for corporates will end any time soon
For my part, I will leave you with the sage advice of J.P. Morgan who when asked how he became rich, responded succinctly:
“I took my profit too early”.