The European Central Bank (ECB) has at last decided to utilize its final weapon, massive and open-ended balance-sheet expansion through the purchasing of sovereign and agency debt, to fight deflation and stimulate the European economies. This quantitative easing (QE) is a so-called “unconventional” monetary policy tool but one already used by the United States, Japan, and the United Kingdom. The experience to date with this approach suggests that in the Eurozone there will be further downward pressure on the euro’s exchange rate; the risk of deflation will be lessened; and interest rates, which are already close to zero, will remain very low for the foreseeable future. Pumping more liquidity into the economy will have only a limited effect in expanding credit unless the demand for credit grows. There are some early indications that credit demand is picking up. In sum, the direct effect of QE on the rate of economic growth may be modest, coming mainly through the lower exchange rate’s effect on exports and a general improvement in business and consumer attitudes.
An important further effect of QE, which my colleague David Kotok explained in a recent commentary, is a rise in asset prices, especially equity prices. QE withdraws duration from the market. Asset prices rise when duration is in demand. As equities are a long-duration asset, this is one positive factor in the outlook for Eurozone equity markets in 2015. It is one of the several reasons we are bullish on Eurozone equities this year.
Optimistic Data
Another reason is the improving macroeconomic situation of a number of the main Eurozone economies. The latest (January 23) Markit Flash Eurozone PMI (Purchasing Managers’ Index) Composite Output Index is 52.2, which is a five-month high. The Flash Eurozone Manufacturing PMI Output Index is also 52.2, a six-month high. France and Italy, however, are moving in the opposite direction, with contracting PMIs. The oil-price decline has led to a drop in input costs in the Eurozone and is feeding through to product prices, a plus for households, which are stepping up their spending. New orders in the Eurozone are advancing at the highest rate in five months.
We expect that the Eurozone’s GDP growth this year could be 1.5%, some 66% faster than the 2014 rate. That will still be only half the US economy’s projected 3% pace, but the acceleration in Europe from a situation of substantial slack to one of above-long-term trend growth will be very positive for profit margins.
EU Vs. U.S. Equities
There is also a valuation argument that lends some support for Eurozone equities in 2015 relative to US equities. The “consensus” P/E estimates for 2015 are 16.9 for the US S&P 500, 14.0 for the Euro Stoxx 50 and 13.4 for the German DAX and also for the Paris Bourse CAC 40. While we do not consider Eurozone stocks “inexpensive” -- a term we would use for Japanese equities -- they do have a modest valuation advantage relative to US equities.
For US dollar-based investors, the prospects for the EUR/USD exchange rate remain an important consideration. This rate has dropped to around 1.12 following the QE move by the ECB. Many analysts and commentators predict that the euro could easily drop to 1.0 -- parity with the dollar -- and even lower, noting that exchange rates often overshoot in corrections. In 2014, exchange rate changes had a very large effect on market returns. While the Eurozone equity markets advanced by 2.26% in the local currency, the euro, the return in US dollars was ‑10.20%, according to the MSCI equity indexes. At Cumberland Advisors we are continuing to use for the Eurozone positions in our International and Global Equity ETF Portfolios ETFs that are hedged against the exchange-rate risk.
Bottom Line
In sum, we believe 2015 is likely to be a good year for the Eurozone equity markets as a group, with Italy and France underperforming; Spain, Belgium and Netherlands outperforming; and Germany at the average for the zone.
Bill Witherell, Chief Global Economist