QE A starting signal for euro area investments?

QE A starting signal for euro area investments? Strategy & Investment The European Central Bank (ECB) has delivered and the attention of investors seems increasingly to be directed towards the old continent. Is a renaissance in Eurozone equities around the corner? There seems to be increasing evidence to this end. Time for a voyage of discovery to Europe. Ann-Katrin Petersen Global Investment Strategist Allianz Global Investors 1 The Eurosystem includes the ECB and the national central banks of the 19 Eurozone member states. 2 That is to say, the purchase programmes for covered bonds (CBPP3) and ABS (ABSPP) approved in September 2014 will be continued with their conditions unchanged. UNDERSTAND: Quantitative Easing (QE) and now what? By approving an expanded asset purchase programme at its Council meeting on 22 January 2015, the ECB has introduced quantitative easing in a major way. For 19 months starting on 9 March 2015, the Eurosystem 1 will purchase not just asset-backed securities (ABS) and covered bonds 2, but also bonds issued by euro area central governments, agencies and European institutions. This will continue at least until the ECB Council recognizes a sustainable correction in the development of inflation that is in line with its objective of achieving inflation rates below, but close to, 2 % over the medium term. This massive quantitative easing is likely to have an impact in three main ways: (1) portfolio effects, (2) weaker currency, (3) normalization of inflation expectations. 1. Portfolio effects Even before the ECB Council meeting, the prospect of extensive securities purchases had pushed Eurozone bond yields right down across the board (with the exception of Greece). The planned purchase volume of EUR 60 billion a month (EUR 40 45 billion of which is accounted for by government bonds) exceeds estimated net new issues of the Eurozone government bond markets this year of approximately EUR 280 billion; this will have a significant impact on demand and should lead to further yield declines. As a result, in their search for positive real returns, investors are forced up the risk ladder, i. e. into riskier assets, and they reallocate their portfolios accordingly. The expansionary central bank policy thus remains a structural plus for equity investments (see Chart 1).

ECB launches massive bond purchasing programme ECB plans to expand its balance-sheet volume Quantitative easing (QE) the key facts again, back to the level seen at the beginning of 2012 3,500 3,000 2,500 2,000 1,500 1,000 TLTROs, ABS, Covered Bonds, Government and Agency Bonds 07 08 09 10 11 12 13 14 15 16 Balance sheet of Eurosystem in EUR bn Source: Thomson Reuters Datastream, AllianzGI Global Capital Markets & Thematic Research 06.03.2015 3,500 3,000 2,500 2,000 1,500 1,000 Expanded purchasing programme: the ECB will buy not only private-sector bonds (ABS, covered bonds), but also public-sector IG* bonds (government and agency** bonds) on the secondary market Huge volume: EUR 60 bn per month, total volume about EUR 1140 bn = 11 % of EMU GDP Unlimited lifetime: 9 March 2015 until at least September 2016, depending on how inflation develops Significant effect on demand: volume of the purchases will exceed expected net government bond issuance of about EUR 280 bn in the euro area in 2015 Maturity range: 2 to (less than) 31 years Structure of government bond purchases: depending on ECB capital key, with a cap at 33 % of an issuer s outstanding bonds and at 25 % of a single issue*** To be implemented by the national central banks Risk sharing: national central banks shoulder the risk for 80 % of the purchases, the remaining 20 % will be shared according to the ECB s capital key *) IG = investment grade **) Bonds issued by certain agencies established in the euro area and certain international or supranational institutions located in the euro area, for example EIB, EFSF, ESM. ***) Limits ensure that the application of collective action clauses for a bondholder decision is not obstructed. Past performance is not a reliable indicator of future results. Sources: Datastream, European Central Bank (ECB), AllianzGI Capital Markets & Thematic Research. Chart 1: QE works via three transmission channels No. 1 Portfolio rebalancing effect Financial repression: Bond yields at historical lows Up the risk ladder : Expansionary monetary policy provides structural support for equity investments 3.0 % 3.0 % 180 5 % 160 140 4 % 120 3 % 100 2 % 0.5 % 0.0 % 0.5 % 0.0 % 80 60 1 % 0.5 % M A M J J A S O N D J F 2014 2015 Yield on 30-year Bunds Yield on 5-year Bunds Yield on 10-year Bunds Yield on 2-year Bunds 0.5 % Past performance is not a reliable indicator of future results. Sources: Datastream, AllianzGI Capital Markets & Thematic Research. 2. Weaker currency From the end of September 2014 until the end of February 2015, the Euro declined in value by about 6 % against its major trading currencies. 3 This nomi nal depreciation of the Euro was largely due to the development of the bilateral exchange rate 40 07 08 09 10 11 12 13 14 Euro Stoxx (rebased) Dax 30 (rebased) Yield 10 year Bunds (rhs) 0 % against the US Dollar. This is because unlike the ECB, the Federal Reserve is aiming for its first interest rate hike in the middle of the year, and the yield differential of Euro vs. US Dollar investments is still one of the most important factors influencing the EUR / USD currency pair. After the announcement 3 In terms of the nominal effective exchange rate (NEER). The NEER is calculated based on weighted averages of the relative changes in the bilateral exchange rates of the Euro against the currencies of the major trading partners of the Eurozone. 2

of the bond purchase programme, the Euro fell to USD 1.12, its lowest level since September 2003. Although it then stabilized temporarily, the bilateral exchange rate in late February was nearly 13 % weaker than at the end of September 2014. The transatlantic divergence of monetary policy suggests that the greenback will continue to gain strength against the single currency. 3. Normalization of inflation expectations There are indications that a further decline in the headline inflation rate can be expected in 2015 due to crude oil prices. The very modest inflation rate in the Eurozone continues to represent a challenge for the monetary authorities, as it seems to be creeping into inflation expectations. This can be seen in the fact that medium and longer-term inflation expectations based on surveys or derived from financial market data fell steadily last year (see Chart 2). However, it is vital that inflation expectations be firmly anchored, since this ensures that temporary movements in inflation rates do not produce second-round effects on wages and prices in the same direction (wage-price spiral) and thus become self-perpetuating. Interestingly, in this context, moderately rising nominal Bund yields resulting from rising inflation expectations would be viewed as a success for the ECB! It will be at least a few months before it will be clear to what extent the ECB s quantitative easing represents a turning point in the fight against possible risks of deflation. At least the highly regarded market-based medium-term inflation expectations have stabilized in the wake of the announcement. Overall, the risk of deflation in the sense of a negative downward spiral of falling prices and wages should be considered low. Although inflation rates are still some distance from the price stability threshold of 2 %, the low inflation is mainly attributable to the sharp drop in oil prices since the summer of 2014 and the necessary structural adjustment processes in some Eurozone member countries. And ultimately the drop in the oil price, which was primarily the result of oversupply, acts as an economic stimulus programme, because declining energy prices are linked to a significant increase in purchasing power for the Eurozone as a net importer. Chart 2: QE works via three transmission channels No. 3 Inflation expectations Still under pressure: Inflation expectations of professional forecasters (SPF*) for 1, 2 and 5 years and market-based medium-term inflation expectations** 2.4 % 2.4 % 3.5 % 3.5 % 2.2 % 2.2 % 3.0 % 3.0 % 1.8 % 1.8 % 1.6 % 1.6 % 1.4 % 1.4 % 1.2 % 1.2 % 0.8 % 0.8 % 00 02 04 06 08 10 12 14 16 Eurozone SPF: expected HICP inflation rate 5 yrs ahead Eurozone SPF: expected HICP inflation rate 2 yrs ahead Eurozone SPF: HICP inflation rate 1 year projection 2012 2013 2014 Break-even inflation 5y5y-Forwards *) Survey of Professional Forecasters **) Medium-term inflation expectations as measured by the break-evens of 5Y5Y forwards, i. e. the expectations for inflation over five years in five years time. Past performance and forecasts are not a reliable indicator of future results. Sources: Datastream, AllianzGI Capital Markets & Thematic Research 3

Markedly improved cyclical conditions Falling energy prices, a weaker currency, less restrictive fiscal policies 4 and more favourable financing conditions for companies (including lower yields on corporate bonds and the third consecutive improvement in the Bank Lending Survey ) 5 should have a positive impact in the coming quarters. This increases the likelihood that despite still lingering (geo)political risks the economic recovery in the Eurozone is being underestimated. Leading indicators such as the purchasing managers index confirm that the Eurozone economy is off to a strong start in the new year, although there are still major differences at country level. The fact remains that the challenges in the Eurozone cannot be fixed with liquidity instruments alone, but will also require economic policy reforms at country level. As regards growth prospects, the dividing line runs increasingly between reform leaders and countries with reforms outstanding, rather than between core and periphery. Institutional architecture of the Eurozone strengthened considerably At European level, a number of reforms have been initiated since 2010 in order to create a more crisisresistant foundation for the Eurozone. These new rules of budgetary and economic monitoring (e. g. stricter Stability and Growth Pact, macroeconomic imbalance procedure), financial market stability and integration (e. g. European banking union) and crisis management (European Stability Mechanism, ESM) have significantly changed the institutional landscape of the Eurozone (see Chart 3). In combination with monetary policy measures, in particular the announcement of possible outright monetary transactions (OMTs) 6, systemic risk has plummeted as the ECB s composite indicator for systemic financial market risks in the Eurozone shows 7. Chart 3: What has been done to improve the euro area s resilience to crises? Institutional architecture of the euro area has been strengthened considerably since 2010 Reduction of government debt Coordination of economic policy Financial market stabilisation New fiscal monitoring Strengthening of the Stability and Growth Pact (by Six Pack / Two Pack rules) Fiscal Compact: structural deficit must not exceed 0.5 % of GDP ( debt brake ) European Semester: coordination of economic and fiscal policy New economic governance Europe 2020: joint growth strategy Euro Plus Pact Macroeconomic surveillance: early recognition and adjustment of excessive imbalances Financial market reforms European System of Financial Supervision (EBA, ESRB, ESMA, EIOPA)* Micro- and macroprudential supervision Stricter regulation (Basel III) European banking union Oversight (SSM), resolution (SRM), harmonized deposit guarantee schemes 4 In terms of the change of the structural budget balance, i. e. the government budget balance adjusted for cyclical and one-off effects. 5 For the first time in more than three years, the Eurozone banks surveyed in the fourth quarter of 2014 saw a noticeable increase in demands for bank loans from non-financial companies. In addition, the institutions surveyed indicated that they have relaxed their standards for corporate loans to a significant degree for the first time since 2007. 6 Possibility of secondary market purchases (whose amount is not explicitly limited in advance) of government bonds of Euro member countries who agree to meet their obligations under an EFSF / ESM programme. 7 The Composite Indicator of Systemic Stress (CISS) includes 15 mainly market-based financial stress measures, equally split into five categories, namely the financial intermediaries sector, money markets, equity markets, bond markets and foreign exchange markets. Relatively more weight is put on situations in which stress prevails in several market segments at the same time. Financial assistance mechanisms Permanent support mechanism: European Stability Mechanism (ESM) with maximum lending capacity of about EUR 500 bn + EUR 200 bn in EFSF financial assistance** Temporary support mechanisms (until July 2013): European Financial Stability Facility (EFSF), European Financial Stabilisation Mechanism (EFSM) *) EBA = European Banking Authority, ESMA = European Securities and Markets Authorithy, EIOPA = European Insurance and Occupational Pensions Authority, ESRB = European Systemic Risk Board **) As the financial assistance already granted to Ireland, Portugal and Greece is not deducted from the ESM s lending capacity, an overall EFSF and ESM lending ceiling of EUR 700 bn applies during the transitional period in which the EFSF and the ESM exist in parallel. Sources: European Commission, Federal Ministry of Finance, AllianzGI Capital Markets & Thematic Research. 4

ACT: Is this the signal to start investing in the Eurozone? longer-term government bonds should thus resist the pull of rising US yields. Crowding-out in the Euro bond market With regard to the Euro bond market, government bond prices should be the primary beneficiaries of quantitative easing. 8 For now, QE should keep bond yields low in the broad spectrum of maturities beyond two years. In the periphery markets (outside Greece), the liquidity effect coupled with brighter economic prospects are likely to result in the continued narrowing of yield spreads compared to German government bonds with equivalent maturities (see Chart 4). This is not least because the default probabilities priced into periphery market bonds are still above pre-crisis levels for the five-year time frame. Chart 4: Euro area sovereign bond markets: Liquidity effects and growth fantasy Risk premia under downward pressure: Yield spreads over 10-year Bunds (in percentage points) 12 % 7 % 11 % 10 % 9 % 8 % 7 % 6 % 5 % 4 % Italy Spain Ireland 2013 2014 France Portugal Greece (lhs) Past performance is not a reliable indicator of future results. Sources: Datastream, AllianzGI Global Capital Markets & Thematic Research. 6 % 5 % 4 % 3 % 2 % 1 % 0 % For government bonds with high credit ratings, on the other hand, the ultra-loose monetary policy seems to have the effect of making negative interest rates the norm. Meanwhile, even yields on German government bonds with terms of up to five (!) years have plunged into negative territory, while the tenyear Bund yield is moving ever closer to the zero mark (see also Chart 1). The Bund curve should flatten further beyond two year maturities due to central bank demand. For now at least, yields on The enormous bond purchases will undeniably distort prices in the entire Euro bond market. In particular, German Bunds are already at ambitious valuation levels and are likely to grow more expensive from a fundamental perspective. Speaking of which: liquidity risks should not be underestimated. Particularly in an environment of falling public debt and the associated decline in new issues, QE could lead to crowding out and bottlenecks in the tradability of government bonds. In extreme cases, the purchases could even lead to a drying up of liquidity in certain segments, as was observed in the Japanese government bond market last year. Conclusion: There is further potential for price gains in the Euro bond market thanks to the large-scale ECB purchase programme. This is especially true for issuers with lower credit ratings. However, as bond yields are already at very low levels in absolute terms, the total return prospects must be viewed as moderate. Against the background of increased liquidity risks, which should not be underestimated in the context of QE, the relative attractiveness (compared to equities) of investments in the Euro bond market has decreased overall. Is a renaissance of Eurozone equities on the cards? There seems to be increasing evidence to this end. Let s take a voyage of discovery around the old continent: From a structural point of view, assets in the Eurozone should benefit not only from the improved financial architecture in the monetary union. In addition, the ultra-loose monetary policy and the associated financial repression remains a structural plus for equity investments. Economic performance in the Eurozone can also be expected to provide positive momentum. In recent months, weaker economic data had led analysts to revise their growth expectations for 2015 downwards. This downward revision trend now seems to be running out of steam; for the first time since May 2014, the consensus growth forecasts for a number of Eurozone countries have turned upward again. At the same time, the macro data continues to stabilize gradually. Driven by the depreciation of the Euro and the decline in oil prices, the (still tentative) economic revival in the Eurozone is likely to gain momentum and, combined with 8 Since the ECB is proceeding according to its capital key and not according to outstanding market volumes, the main beneficiaries of the bank s bond purchases will be relatively lowdebt countries with low issue activity (such as German government bonds) as well as Eurozone countries whose bonds are fairly illiquid. 5

the end of the downward trend in revisions, be the source of positive surprises, thus providing a cyclical tailwind for the Eurozone equity markets. In addition, the decline of the European single currency should boost the outlook for corporate earnings in the Eurozone (see Chart 5). This is because the Eurozone generates about 45 % of its income from outside the region. In comparison to the US in particular, there is still substantial potential for earnings to catch up. The gap in the development of index gains on both sides of the Atlantic had moved apart significantly in recent years. In the next few quarters, a counter-movement in favour of equities from the Eurozone is expected, with the weak Euro also making a contribution here. Despite the temporary jumps to new record highs, European equities remain attractively valued in a global comparison, especially in terms of the Shiller price / earnings ratio (Shiller PE ratio), a valuation measure suitable for longer-term investment decisions. The calculation of the Shiller price / earnings ratio is based on the rolling 10-year average earnings of companies. As a result, the Chart 5: Weaker Euro exchange rate is likely to fuel momentum in Eurozone earnings revisions Euro Stoxx earnings revisions momentum* (3months moving average) and trade-weighted euro exchange rate 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3 Strong euro long period of earnings downgrades Euro exchange rate about to become a tailwind 2012 2013 2014 2015 Euro Stoxx earnings revisions (3 months moving average) lhs Trade-weighted euro (JPM index), 2000 = 100, inverted rhs *) Ratio of upwards to downwards earnings estimates. Past performance is not a reliable indicator of future results. Sources: IBES, Datastream, AllianzGI Capital Markets & Thematic Research. 115 120 125 130 135 140 145 price / earnings ratio smoothes cyclical fluctuations, and temporary, one-time influences are excluded. There is still a discount of approximately 25 % against the global index (MSCI Europe vs. MSCI World). 9 The dividends distributed play a crucial role in the total return of an equity, even more so in a world of lower trend growth and extremely low bond yields. Dividend yields on European securities continue to be comfortably above the 3 % level 10 and offer a significant yield advantage over the current yield on European corporate bonds and 10-year Bunds equity interest instead of bond interest as the saying goes. Declining net debt to equity ratios and rising cash on the balance sheets of European companies combined with relatively low payout ratios (i. e. scope for higher dividends) give dividends further upside. Incidentally, US investors have already started the voyage of discovery to Europe. This can be seen in the considerable net inflows from US investors into European equity portfolios, which amount to more than USD 8.7 billion since the beginning of 2015. Imprint Allianz Global Investors GmbH Bockenheimer Landstr. 42 44 60323 Frankfurt am Main Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn), Ann-Katrin Petersen (akp), Stefan Scheurer (st) Data origin if not otherwise noted: Thomson Financial Datastream. Calendar date of data if not otherwise noted: March 2015 9 Data as of January 2015. 10 As measured by the MSCI Europe Index an attractive level compared to US and Emerging Markets securities, too (as measured by the MSCI US and Emerging Markets Indices, respectively). 6

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