The October 31st announcements from the Bank of Japan, and the resulting moves in the Yen and Japanese equities, reemphasize the impact that central banks and monetary policy can have on markets and portfolios. When central banks are involved in markets, headlines can often shift market outlooks and investor confidence. Unprecedented monetary policy has the ability to turn countries with weak fundamentals, poor momentum, and high risk into top performers, much like Italy and Spain in late 2012/early 2013. Recall the summer of 2012, when ECB president Mario Draghi pledged to do “whatever it takes” to save the Euro, causing the risks surrounding Italy and Spain to evaporate, and sparking a period of impressive outperformance for relatively unattractive high risk countries. For investors willing to take a more tactical approach to the markets, Germany appears well positioned to benefit from the unveiling of ECB monetary policy and the further stabilization of the Russia-Ukraine conflict.
Uncertainty surrounding the ECB’s Monetary Policy and Russian Sanctions remain in focus for global investors:
ECB Monetary Policy
- ECB president, Mario Draghi, has pledged to expand the central bank’s balance sheet by as much as 1 trillion Euros, reversing a two year downtrend and targeting the peak balance sheet level last seen in 2012.
- German opposition to the ECB buying sovereign bonds means the ECB will buy covered bonds and asset-backed securities (limited supply) to expand their balance sheet.
- Covered Bonds and ABS appear to be the first target of the ECB, but if the ECB cannot find enough covered bonds and ABS to buy, they will have to consider corporate and government bonds as well.
- The objective of ECB policy will be to create inflation, weaken the Euro, and entice investment/spending.
The Russia-Ukraine Conflict
- Economic sanctions between the EU and Russia have negatively impacted Europe’s business confidence and investor sentiment more than economic and corporate fundamentals.
- The message being sent by the West is that Ukraine needs to find a way to co-exist and trade with its imposing neighbor, just as Finland did after World War II.
- We anticipate that the current ceasefire will hold, but that Russia maintains de facto control, creating a “militarized demilitarized zone” akin to what evolved in Moldova in 1992 and Georgia in 2008.
- European policymakers will start to dial back sanctions once they see signs of a credible truce.
These two sources of uncertainty have impacted European economies and equities in different magnitudes. As new risks are priced into markets, “country risk premiums” expand. In other words, if Germany’s equity market sells off, and all else is held constant, the return potential/risk premium of Germany expands as equity prices decrease. Importantly, “all else” is never “held constant” in reality. As German equities sell off and new risks are quantified, valuations, momentum, risks, and fundamentals change. Importantly, there are some cases where prices deteriorate more than fundamentals, risk, or valuations justify, creating an opportunity to invest in a market that has dislocated from its underlying intrinsic value. A dislocation from intrinsic value is the first parameter we look for in a tactical opportunity. The second parameter is a performance catalyst. Many market dislocations persist because of the absence of a catalyst. Similar to a value trap, absent any reason/driver for improved fundamentals or growth, valuations and prices are likely to stagnate or continue lower. With a meaningful catalyst on the horizon in Europe, the opportunity for risk premiums to narrow is becoming more real.
Regarding the investment thesis for Germany, the stabilization of the EU-Russia trade relations and the unveiling of ECB Quantitative Easing should significantly reduce the macro-uncertainty associated with Germany, allowing for meaningful appreciation and mean-reversion in equity prices and investor confidence. Of the EU’s four largest economies, Germany has been the weakest equity market since the beginning of the Russia-Ukraine conflict (chart below).
MSCI Country Equity Index Performance – Since Russia Invasion of Crimea
The Russia-Ukraine conflict has impacted economic sentiment in Germany more than most European countries. Russia invaded Crimea on February 27th of this year. Since that time German equities are down more than 9% in Euro terms and 16% in USD terms. In 2013, only 3.4% of German total exports went to Russia, while 5.1% of all imports came from Russia. It can be said that German business expectations and economic sentiment have been more negatively impacted than the long run economic fundamentals of the country. Since the implementation of sanctions on Russia, German business expectations and economic sentiment have rapidly deteriorated (chart below). Markets appear to be extrapolating the impact of Russian sanctions and Euro Area deflation into the future, driving down equity prices and creating an opportunity for investment in Germany.
German Expectations of Economic Growth (ZEW), Business Expectations (IFO), and Manufacturing PMI
Over the last six weeks, markets have seen CDS spreads widen for Italy, Spain and France, while CDS spreads have narrowed for Germany (suggesting less risk of government default). This data could imply that market participants are becoming less focused on Russia’s impact on German fundamentals (despite sanctions on Russia being increased on Sept 12th) and are becoming more focused on ECB monetary policy, bank stress tests, and the European Commission’s review of government budgets.
Sovereign 5 Year Credit Default Spreads (CDS) – Since 3rd Round of Russian Economic Sanctions
It is reasonable to expect that Italy, Spain and France will benefit from ECB action and a weaker Euro, but given Germany’s economic profile and focus on net exports, it is reasonable to expect that German companies have more to gain from a weaker currency (especially against the USD, RMB, and GBP). In 2013, 10.3%, 8.5% and 7.8% of total German exports went to the United States, China, and the United Kingdom, respectively. A weaker Euro makes German exports more competitively priced in each one of these markets, providing German companies with an opportunity to increase profitability or market share.
Furthermore, a weaker Euro, negative real interest rates, and expansion of the ECB balance sheet through quantitative easing could improve the economic prospects of the Eurozone as a whole and reduce the risks of deflation. To the extent that the ECB can stimulate inflation and investment, Germany will benefit from a stronger Europe. Importantly, the long fun fundamentals and underlying valuations in Germany balance the uncertainty surrounding the Russian and ECB catalysts. To the extent that our outlook on sanctions and ECB monetary policy is wrong, we suspect that Germany has the “fiscal space” to defend domestic growth and will continue to be a low risk, blue chip, value play for the Euro region and the global economic recovery.
Germany has attractive valuations and a low-risk profile (table 1 below). The problem with Germany, since the beginning of 2014, has been negative momentum and weakening fundamentals (table 2 below). Trailing 12 Month EPS growth and leading economic indicators are weak in Germany. However, Germany’s Long Term EPS Growth Rate is 13.15% compared to a 40 country average growth rate of only 7.09%. Looking forward, analyst’s consensus for earnings growth for the next 3 to 5 years is 11.1%, versus a 40 country average of 12.3%.
If the uncertainty surrounding the catalysts outlined above dissipates, there is an opportunity to capitalize on expanding valuations and improving confidence in Germany. The stabilization of the Russia-Ukraine conflict should improve economic sentiment and investor confidence in Germany. Additionally, low real interest rates and a weakening currency stand to strengthen European and German fundamentals and local currency price momentum.
The median estimate in forecasts compiled by Bloomberg is for the Euro to drop to $1.20 by Q4 2015. To best capture the potential benefits of these two catalysts investors should consider using a currency hedged ETF. These investment products provide exposure to the underlying equity markets of a country (Germany), while at the same time neutralizing the effects of any local currency (Euro) strength or weakness against the US Dollar. The two available currency hedged ETFs for Germany are HEWG and DBGR, and both effectively neutralize the impact of a weaker Euro on investment returns. HEWG and DBGR have the same underlying holdings (company and sector allocations are approximately equal to the MSCI German Index). As a result, the historical performance these currency hedged ETFs is nearly identical, DBGR may have a slight edge over HEWG only because it has a lower expense ratio.