Although sentiment towards European equities has improved since I wrote about it last Fall (Pretty sure I am alone in this trade), this opportunity is not something that will be quickly arbitraged away. Not only that, but deep down, investors are still skeptical about the long term prospects for European equities. Sure, they are willing to surf European equities for a wave or two, but ask them where they are willing to invest for the long haul, and Europe is rarely in the running as a top pick.
I understand their pessimism. Europe has a lot of problems. Poor demographics, an unstable political union, layers of bureaucracy, the list goes on and on. It’s tough to imagine Europe being a great place to park your money.
Yet too many investors mistakenly believe good old fashioned fundamentals still drive financial asset markets. Nothing could be further from the truth. Since the 2008 credit crisis, Central Bank flows have made a mockery of financial pricing theory.
How do you determine the fair value of assets, when the risk free rate which most other assets are priced off, is negative?
Try putting negative yields (or even just tiny yields) into the Fed equation model and figure out the price for a stock index.
The current situation in Europe is remarkably similar to the U.S. period of 2010 to 2014. At that time, most investors were extremely negative about America’s prospects. Many investors called it a “sugar high” induced by the Fed’s continual balance sheet expansion. There were all sorts of forecasts of doom. Yet stocks kept climbing… and climbing.
The same thing will most likely happen in Europe. The ECB is aggressively expanding their balance sheet, and they have even pushed short term rates to absurdly negative levels. Their monetary policy is just bat shit crazy.
Lately the market has started to wake up to the relative cheapness of European equities, and there has been a pronounced swing from America to Europe. In fact, since the Trump election victory, European stocks have now outperformed American equities.
I know that it seems like European stocks have run too far too fast. It’s easy to think they might be due for a pause.
But I wanted to stress, that in the longer term picture, this move is so small, it’s something that the band Kansas would sing about.
European stocks have gone no where for the past decade and a half. Yeah, it’s probably deserved, I get it. But now we have a committed Central Bank, which seems to have adopted Paul McCulley’s mantra of being “responsibly irresponsible”, combined with a dirt cheap stock market, and a global economy that seems poised to grow.
Contrast that to America where the stock market is richly priced, with Federal Reserve that appears to be hell bent on withdrawing accommodation as quickly as the market will let them.
At the end of last year I wrote that buying European equities and shorting German bunds was The Best Trade on the Board. This latest rally in the European equities is just the start. The cost of European debt is just dirt cheap versus equities.
There is still a massive incentive for European companies to issue debt and buy back stock. And this financial repression will force investors out the risk curve for some time to come.
It will take many, many quarters of equities rising and European bonds falling for this arbitrage to return to normal.
Make sure you step back and burn this chart into your mind. This is all that matters. Ignore all the talk about Europe’s doom. Don’t pay attention to financial models that indicate European equities are too expensive (they are - just not when you take into account the moronic price of bonds). Forget about the financial analysts that are forecasting earnings ratios. All this stuff doesn’t matter anymore.
Central Banks have distorted asset markets to grotesque levels, and nowhere more so than Europe. But don’t think this means it will end in a crash. Remember, they will continue printing until the bond market takes away the keys. Until the bond market revolts, being long European equities is the right trade.
In the upcoming months, there will be a lot of chatter about the ECB’s winding down of their quantitative easing. But unless they quit cold turkey, there is nothing to worry about. They will still be buying an absurd amount of bonds for many quarters to come.
Every time you get a nagging moment of doubt, remember that the U.S. market climbed that very same wall of worry. And then remember, today, the ECB is even more aggressive than the Federal Reserve was back then. And this is at a time when the global economy is actually much more healthy!
The chance of a European equity melt up has never been more intense.
Thanks for reading,