In most superhero movies, a dysfunctional government struggles to maintain law and order before a caped crusader comes to the rescue. For European markets, central banks have played the superhero role to great effect in recent years. But what happens if their powers fade? Are we prepared for a return to the volatility of old and a more challenging path for investors?
Since the global financial crisis, markets have had two principal Guardians of the Galaxy: the U.S. Federal Reserve's Ben Bernanke and the European Central Bank's (ECB) Mario Draghi. They have been supported, Avengers-style, by a host of other central bankers, who have engaged in an unprecedented, coordinated period of loose monetary policy.
But the days of omnipotent central bankers saving the day are over. That old foe, Greece, is dominating the headlines again but the situation now is very different to 2011. While there may well be further easing measures to come, our superheroes' marginal impact will be minimal.
In Europe, the ECB has finally delivered on an expansive quantitative easing (QE) package. However, its effectiveness on the real economy will be questionable. While in the US, QE helped to relax credit constraints for a large part of the real economy, firms in the Eurozone remain more reliant on bank lending. For every 10 euros borrowed by European companies , about 8 euros comes from a bank and only 2 euros from the capital markets. In the U.S., the reverse is true.
The "wealth effect" from inflated stock and real estate prices will also be less pronounced. According to the ECB, housing wealth does little to spur consumption in the Eurozone. Financial wealth has a larger impact, but it is still lower than in the US, where households often own stocks and property for their pensions.
Attention will now have to turn to our elected policymakers and fiscal stimulus to deliver sustainable and inclusive growth.
Unfortunately, fiscal stimulus is challenged by the restrictions of the Fiscal Compact which continue to bind peripheral Europe. For Italy, France and Portugal, limited progress in deficit reduction means even more fiscal tightening this year. As seen by the latest Greek debt deal, Germany will continue to play an important role if countries seek to negotiate their fiscal restrictions. Tensions will persist between governments, as well as within.
While there has been some progress in structural reforms, there is a long way to go. Peripheral countries have successfully achieved greater cost competiveness, but much of this has come through wage freezes and at the cost of high unemployment, which for the euro zone overall persists at above 11 percent. Labour market reform still remains a high priority, and youth unemployment is particularly worrying. In Spain, more than half of the population aged under 25 is without work.
The diminishing effect of the central bank backstop would be enough on its own to suggest more market volatility this time around. But there is another crucial difference, warranting further caution – valuations. At the time of the second Greek bailout package in October 2011, the price/earnings ratio of the MSCI Europe Index was 14 times. Today, it stands at 23 times. As for fixed income, yields for a quarter of Eurozone sovereign bonds have fallen into negative territory.
Against this backdrop, are investors too sanguine on political risk? In 2015, we have elections in Spain and Portugal, where unemployment levels remain elevated and public grievances have only escalated over the past five years. As in Greece, anti-austerity parties are gaining traction and election results are increasingly difficult to forecast. At the height of the euro zone's crisis in 2011, investors had the comfort of established parties on which to anchor their policy expectations. Not anymore.
While elections are further away for France and Italy, both countries still face political uncertainty. Popular and parliamentary support for their governments is waning fast. This became increasingly clear as the French government resorted to political decree to push through a package of structural reforms in the face of opposition from its own supporters.
Across the Channel, the debate on the level of European integration is central to the impending general election. While not a member of the currency union, the formation of the UK's government will have an important bearing on the rest of Europe, and a majority government seems an increasingly unlikely outcome.
What does this mean for investors? Within fixed income, a dynamic, active approach has never been more important in order to generate real gains. With yields at historic lows, and as dysfunctional politics again comes to the fore, capital preservation might be the best-case scenario for passive allocations.
Corporate spreads have also compressed considerably to such an extent that Nestle's bonds recently traded with negative yields. On top of duration risk, diligent underwriting is therefore increasingly important. This is especially true in the high yield space, where we are seeing numerous first-time issuers with no credit history.
As for equities, investors must also anticipate increasing influence from politics. Country, sector and stock selection will play an important role in mitigating these risks.
Gotham struggled when Batman left. Central bankers are in the process of hanging up their superhero capes and it is doubtful that politicians can easily fill their role. While markets appear unconcerned, the Greek debt saga isn't over. More than that, it probably represents the beginning of what is to come in the European year of politics.
Alexander Friedman is the Group Chief Executive Officer of GAM.
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