Perspective. Economic and Market. Buying the Eurozone?

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1 James W. Paulsen, Ph.D. Perspective Bringing you national and global economic trends for more than 30 years Economic and Market October 10, 2014 Buying the Eurozone? The speed by which the eurozone has returned to crisis is unnerving, but for several reasons we think the recent panic may represent an opportunity for investors. First, while eurozone stocks have underperformed U.S. stocks significantly in this recovery, they have traded in a broad range relative to U.S. stocks since the fall of 2012 and currently reside near the low end of this range. Second, because of very different policy responses to the 2008 crisis (i.e., eurozone policy officials initially addressed the crisis with fiscal austerity while U.S. officials immediately implemented monetary stimulus), we believe the eurozone economic recovery has been trailing the U.S. recovery by about two years and expect it to close the gap relative to the U.S. in the next couple years. Third, economic conditions in the eurozone have recently worsened which will likely force policy officials to soon introduce more aggressive stimulus at a time when U.S. policies are turning more restrictive. Finally, the U.S. dollar has recently strengthened substantially relative to the euro. The euro-dollar exchange rate is now near the lower end of a range which has been in force for almost a decade. Consequently, U.S. investors can buy eurozone stocks today with a reasonable expectation returns could be boosted should the euro revive some in the next year. Are eurozone stocks collapsing or nearing support at a trading range low? As illustrated in Exhibit 1, relative to U.S. stocks, eurozone equities have collapsed recently. While they have mostly underperformed the U.S. stock market throughout this recovery, since mid-2012, eurozone stocks have established a major relative trading range and the recent selloff leaves them near the lower end of this range. At a minimum, eurozone stocks have become considerably cheaper in recent months. What does this recent weakness represent? Are eurozone stocks about to break below their two-year trading range and establish new relative lows? Or, will the recent weakness in eurozone stocks prove to be a great buying opportunity relative to U.S. stocks as it was in both mid-2012 and mid-2013? Although a new relative low is certainly possible, we think the recent swoon in eurozone stocks is probably an opportunity to buy cheapened stocks in a panic which is likely to prove temporary. Exhibit 1: Eurozone stock market Relative price performance MSCI eurozone stock price index relative to MSCI U.S. stock price index, U.S. dollars Since the 2008 crisis, the best buying opportunities have occurred where fear dominates the pricing of assets (e.g., buying stocks in March 2009 against widespread fears of a run on the U.S. banking industry, buying the astronomical government yields available in Europe as most feared the eurozone was imminently coming apart, and betting against the U.S. going over the fiscal cliff). Therefore, despite a consensus of investors currently avoiding equities in the region, should investors consider overweighting the eurozone?

2 2 Is the eurozone recovery trailing the U.S. recovery by two years? The U.S. and the eurozone initially adopted very different economic policy approaches to the 2008 crisis. The U.S. eased interest rates, injected liquidity, and did nothing to mitigate ballooning government deficits. By contrast, eurozone policy officials opted to initially implement a fiscal austerity program. While U.S. officials injected monetary stimulus, eurozone officials responded by tightening fiscal policy. Exhibit 2 illustrates the impact of these contradictory economic policies. For two years between mid-2010 and mid-2012, while U.S. bond yields mostly declined, eurozone bond yields rose steadily! The result was two entirely different economic paths during the early years of the current global recovery. The U.S. began a slow but steady economic recovery while the eurozone collapsed back into recession and nearly had its monetary union unravel. Eventually, by the fall of 2012, economic conditions became so weak in the eurozone, that European Central Bank (ECB) officials had no choice but to respond much more aggressively. This helped to arrest and reverse the problematic surge in bond yields throughout the region and ultimately ushered in the beginning of a recovery. However, by then, the eurozone economic recovery was already two years behind the U.S. recovery. This is not only true in terms of time but also in character. For example, U.S. consumer confidence today is near recovery highs while investor confidence still resides near crisis lows in the eurozone. The recapitalization of the banking industry and the renewal of the credit creation system is not nearly as Exhibit 2: Diverse paths U.S. 10-year Treasury Bond Yield healthy yet in the eurozone, its unemployment rate remains near crisis highs, and eurozone corporate profits, as well as overall economic growth, have so far improved far less than in the U.S. Fundamentally, the U.S. economy is probably at least two recovery years ahead of the eurozone. However, with economic policy in the region finally headed in a more appropriate direction, the fact that eurozone recovery fundamentals are still behind those in the U.S. may (perhaps perversely) represent a favorable investment attribute. Consider what has driven the U.S. stock market consistently higher in the last few years. Wasn t it primarily due to the replacement of fear with a revival in fundamentals? U.S. stocks surged higher because the unemployment rate finally began consistently and significantly declining, because job creation became commonplace again, bank loans finally began to persistently rise, housing activity finally came to life, and confidence throughout the economy finally improved. The U.S. economy will continue toward prosperity during the balance of this recovery. However, with ECB President Mario Draghi now arguing for and most likely soon adopting the Bernanke approach of ease, ease, and then ease again, won t eurozone economic improvements going forward likely prove even more dramatic (because their fundamentals are currently so much worse) than will be the case in the U.S.? If the economic gap between the U.S. and the eurozone closes somewhat in the next couple years, it seems likely the performance gap between the two stock markets will also be reduced. Eurozone 10-year Government Bond Yield Median yield of 10-year government bonds for Germany, France, Italy, Portugal, and Spain

3 3 Is the eurozone stock market exhibiting the monetary policy ebb and flow which has characterized the U.S.? Throughout this recovery, performance of the U.S. economy and that of its stock market has ebbed and flowed in conjunction with the implementation of monetary easing. This is illustrated is Exhibit 3 which overlays the U.S. stock market with the level of aggregate reserves held at the Fed. Quantitative easing (QE) in the U.S. has proved a volatile affair. QE1 sparked a rally in 2009 but stalled once the Fed stopped the program. QE2 commenced in early 2011 and was associated with another upward leg in the stock market but again stalled once the Fed paused its monetary operations. Finally, QE3 was initiated in late 2012 and the stock market and the economy have again enjoyed a period of good performance. Now, however, as QE3 winds down, the stock market again appears to be struggling. Exhibit 3: U.S. stock market ebbs and flows with monetary policy U.S. stock market versus Federal Reserve aggregate reserves Left scale S&P 500 Stock Price Index, natural log scale (Solid) Right scale U.S. base money. Aggregate reserves of deposit institutions held at the Federal Reserve, natural log scale (Dotted)

4 4 Since the ECB first became more accommodative in September 2012, the eurozone has also exhibited a similar ebb and flow attribute seemingly tied to the implementation of monetary policy. Exhibit 4 shows that until 2012, eurozone monetary reserves remained modest and bond yields in the region generally rose. However, once Mario Draghi finally came to the rescue of the region in September 2012, bond yields began to decline and reserve levels were significantly enhanced. This first move by the ECB could be viewed as the first round of America s QE1 (call it Draghi 1) only with about a two-year lag. And, like in the U.S., this monetary stimulus worked. Eurozone economic activity improved, widespread worries over an imminent breakup of the region subsided, and as the lower chart shows, the eurozone stock market began outpacing U.S. stocks. Like in the U.S. though, by 2013, ECB stimulus began to be pulled back. Bond yields stopped declining and reserves on the ECB balance sheet began declining. Similar to the U.S. experience, once the eurozone pulled back from Draghi 1, improvement in the eurozone economy and stock market stalled. Recently, because the eurozone stock market has collapsed (significantly as shown in Exhibit 4 relative to U.S. stocks) and while economic reports in the region have turned disturbingly weak, similar to the U.S. experience, the ECB seems poised to soon begin Draghi 2! If the U.S. offers any insight as to the future character of the eurozone (since ECB policy now appears essentially a lagged version of the ebb and flow character of U.S. monetary policy), do investors really want to miss out on this stock market when Draghi 2 appears imminent? Don t forget the U.S. economic and financial market outlooks appeared equally bleak before every fresh round of U.S. QEs (e.g, remember the fiscal cliff in late 2012 before QE3?). Exhibit 4: Is eurozone starting to follow ebb and flow policy of U.S.? Eurozone monetary policy Reserves and yield Left scale ECB balance sheet All assets, natural log scale (Solid) Right scale Median yield of 10-year government bonds for Germany, France, Italy, Portugal, and Spain (Dotted) Eurozone stock market Relative price performance MSCI eurozone stock price index relative to MSCI U.S. stock price index, U.S. dollars

5 5 Unlike in the U.S., the eurozone has yet to give up the Armageddon ghost!?? Another reason to currently be optimistic about the prospects for the eurozone, is because unlike in the U.S., the eurozone culture has yet to give up the Armageddon ghost. Exhibit 5 illustrates confidence measures for both the U.S. and for the eurozone. After the 2008 crisis, U.S. confidence remained mired neared post-war lows until the end of In the last couple years, however, it has revived to near seven-year highs! For years after the 2008 crisis, most economic players were frozen by fears that yet another Armageddon ghost lied just around the corner. Fearing the end of world was near, consumers, businesses, and investors behaved extremely cautiously. Why would anyone buy a house or car (even if they could) if convinced another crisis was nearing? Why hire anyone or invest in the stock market? So, for the first several years of the economic recovery, despite zero short-term interest rates and record low mortgage yields, housing activity was nonexistent, the unemployment rate remained stubbornly high, job creation disappointingly weak, and the stock market sold at only about 13 times earnings. Suddenly, about two years ago, Exhibit 5: Giving up the Armageddon ghost??! Conference Board U.S. Consumer Confidence Index confidence began to rise because most finally gave up the Armageddon ghost. While economic growth remained weak and problems still persisted, most simply got tired waiting for one of the many popular stories forecasting the end of the world. Suddenly, as confidence in a sustained recovery finally emerged, home and car sales rose, job creation became commonplace, the unemployment rate began a persistent decline, and the stock market swiftly was worth 18 times earnings! Essentially, the U.S. stock market sold at a significant discount to its potential valuation until investors finally gave up the Armageddon ghost (indeed, the price-earnings multiple on the S&P 500 rose from about 12 to about 18 times earnings or 50% as the confidence index shown in Exhibit 5 increased from about 60 to about 90)! As shown in Exhibit 5, eurozone confidence remains stuck at very low levels because the culture is still dominated by considerable doubts about the future. Should successive rounds of ECB stimulus ultimately triumph over economic fundamentals as they did in the U.S. (or at least enough to convince the populace that the eurozone is not imminently likely to blow apart), considerable stock market performance in this region could be forthcoming. Sentix Eurozone Economic Sentiment Index Survey based on 4,500 private and institutional investors

6 6 Buy the euro at the low end of its 10-year trading range! Most think the U.S. dollar will continue to strengthen while the euro continues to weaken. However, we believe currency rates among developed economies have effectively (not officially) been pegged to each other for the last several years and currently the euro-dollar exchange rate is at the low end of this range. Exhibit 6: Euro/dollar nearing bottom of 10-year trading range Euro/U.S. dollar spot currency rate Price of one euro in U.S. dollars Developed economies share a common overriding economic characteristic aging demographics. This has slowed potential economic growth among most older established economies. Since growth is so precious, no developed economy will allow another to steal growth away using cheap devaluations. This universal competition for scarce economic growth has effectively confined developed country exchange rates to narrow bands evident now for several years. As shown in Exhibit 6, the euro-dollar exchange rate has remained in a relatively narrow range (mostly within 20%) for a decade. The degree by which the euro-dollar exchange rate is pegged is illustrated by how little the euro currency was impacted when the eurozone was widely thought to be blowing apart. If a potential breakup of the European Union cannot force the euro-dollar exchange rate outside its decade long trading range, we doubt it can be breached because of the recent slowdown in the eurozone economy. Should the euro-dollar exchange rate remain in the trading range illustrated in Exhibit 6, the euro is currently a good buy! Consequently, U.S. investors who increase allocations toward eurozone equities may also benefit in the next year from improved currency repatriation returns. Many also believe the U.S. dollar will continue rising against the euro since the Fed is slowing accommodation while the ECB is likely to soon accelerate easing. However, what is important is not the actual act of monetary easing or tightening, but rather how these actions are perceived. For example, if the U.S. Fed is forced to tighten because of rising inflation fears or fears the Fed is behind the curve, this would likely be destructive for the U.S. dollar. Likewise, if ECB easing is mostly perceived as helping improve eurozone growth, this could bring a bid to the euro. Indeed, as shown in Exhibit 6, in 2012 when ECB President Draghi first began monetary easing, the euro rallied from levels not that far from where the euro-dollar currency rate resides today.

7 7 Summary? A recurring successful investment approach throughout this recovery has been buying when prices come under pressure because of excessive fears. Current panic surrounding the eurozone has already caused the MSCI EMU stock price Index to decline by almost 10% in local currency terms, while in U.S. dollar terms, the eurozone ETF stock index is off by about 18% from recent highs. Current anxieties surrounding the eurozone could persist or worsen in the coming months and we certainly do not know when and where the eurozone stock market will ultimately bottom. However, for several reasons, U.S. investors should begin taking advantage of the recent weakness in these markets by slowly moving equity allocations toward an overweight in the eurozone. First, relative to U.S. stocks, eurozone equities now reside at the low end of a trading range which has been evident since mid Second, because of very different policy responses to the 2008 crisis, we believe the eurozone economic recovery has been trailing the U.S. recovery by about two years and may start to close the gap relative to the U.S. in the next couple years. Third, economic conditions in the eurozone have recently worsened significantly which will likely force policy officials to soon again introduce more aggressive stimulus at a time when U.S. policies are turning more restrictive. Finally, the U.S. dollar has recently strengthened substantially relative to the euro. The euro-dollar exchange rate is now near the lower end of a range which has been in force for almost a decade. Consequently, U.S. investors can buy eurozone stocks today with a reasonable expectation returns could be boosted should the euro revive some in the next year.

8 8 Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profi t as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at or refer to our Form ADV Part II, which is available upon request by calling is a registered service mark of Wells Capital Management, Inc. Written by James W. Paulsen, Ph.D For distribution changes call Wells Capital Management