Q1 2014: April 7th, Europe, Japan, Emerging Markets
April 7, 2014
Europe
Europe opened 2014 with the residual benefit of 2013. No longer in the recession it suffered from over much of the past three years, the Old World appears to be able to look forward to better times. A historic low rate from the European Central Bank (ECB) could be the catalyst to spur new lending and an increase in credit on the Continent. That development has yet to be seen, but there is a bright side. Commercial banks are finally selling distressed assets at a higher pace, and peripheral bond yields across a wide swath of southern Europe declined sharply the first three months. So much so, that sentiment remains bullish there will be further drops in longer-term yields, and for the first time since before the financial crisis, five-year yields are lower in Europe than in the United States. The yield curve is flatter than in the U.S., but the benefits of a relatively steep yield curve, especially for the banking sector, are being realized.
An area of concern that remains from late last year, is the ultra-low level of inflation, which is running at an annualized 0.5% through the month of March, much below the ‘close to but below 2%’ mandate of the ECB. So far, Mr. Draghi has voiced a seeming intent to act, if the situation warrants, in the not-too-distant future. Last week’s meeting, after quarter’s end, indicated a long discussion with greater unity on what may be the next step if disinflation declines into zero inflation. Of importance, Germany appears to be on-board with this new thinking, as the Bundesbank president did not dismiss outright the possibility of outright bond purchases, leaving the proverbial door open for more stimulus. However, whether or not Eurobonds are endorsed is an open question, though being more creative, the added incentive of regulated stress tests scheduled for later this year may encourage banks to clean-up their balance sheets and recapitalize.
The mechanism the ECB settles-on will indicate the extent the German government is willing to step-away from austerity and embrace a new strategy in Europe. One idea that’s been floated is putting to greater use the European Stability Mechanism (ESM), on the books since Europe’s crisis reached a breaking-point in 2012, but not applied as it made its way through Germany’s constitutional court. That legal process is over, with the result that lending within the European Union has been ratified, and so a new avenue has been opened. Whether it is used to its fullest, and seen as a large part of the solution to recapitalize the banking system remains to be seen, but likely an unknown to be known before the calendar year concludes.
The peripheral story has flown under the radar with much of the market’s attention on the inflation story, but is a bright spot indeed. From its darkest days, as the saying goes, it’s come a long way. Now, that needs to be turned into a better lending environment. Lower rates are only beneficial if there is an increase in lending power and the wheels of credit do their magic. Let’s not forget, Europe is far more dependent on its commercial banks to provide corporate credit than in the U.S. In numbers, where in the U.S. it is less than 25% of the total, with the rest raised directly through the capital markets, the numbers are reversed in old Europe.
On the equity front, Europe had a good quarter, with the EuroStoxx 600 slightly outperforming the S&P 500 Index. Individual bourses were more mixed, in particular, the DAX showed a small decline in Q1, with geopolitical tensions having greater direct and indirect influence in Europe’s largest economy. The Euro held-up well, after a very good 2013 in which the single currency appreciated 4% vs. the U.S. Dollar, and more so against Japan’s Yen.
A few words about the U.K. Its economy picked up the pace earlier and faster than the rest of Europe. Inflation was low, but not excessively so, the new central banker came in with much credibility, and all that said, markets believe the Bank of England may be the first of the big four to raise interest rates, perhaps before 2015. This possibility was strongest around the middle of the quarter, but economic data in March may delay any such move. And so, the yield in 10-year Gilts has leveled-off and Sterling has as well over the past fortnight or somewhat longer, since early in March.
Japan
Japan opened 2014 on a down note. That was partly a result of a superb 2013, where with two of the three cylinders cranking, it was enough to result in a steep currency devaluation, plus an equally steep stock market recovery. All told, the Yen lost approximately 20% against its major G7 counter-parties, and the Nikkei gained over 50% in the local currency, and roughly-half that amount in Dollar terms. In the meantime, Japanese long-term bonds (JGBs) stayed range-bound, below 1%, and consumer inflation, long a villain to the Bank of Japan rose above 1%. A banner year.
This year, the stakes remain high, but the bar is set much higher. Solely, adding monetary stimulus will not catapult the Nikkei higher and the Yen lower. Markets want to see the third arrow, structural reforms, begin to take shape. Nothing in Japan moves with earth-shattering speed, but it is important to see evidence (similar to Europe) of new creative thinking that goes beyond much repeated practices. Shinzo Abe was something new in his second go-around as prime minister, he still possesses wide majorities in both parliamentary houses. The bottom line is that markets are looking for Abe to do more.
The new fiscal-year opened in Japan (April 1st) with the thought more stimulus may be coming to offset an increase in the consumption tax, though not likely to be right away. Equity markets after a very volatile winter have been in recovery mode the past three weeks or so, reducing a sharp decline, more than a 10% correction for the Nikkei, before paring the loss in half as the quarter closed. The Yen too has been retracing its earlier gains, a key element to the BoJ’s goal of reaching its inflation target of 2% by the end of the next fiscal-year. We opened 2014 with Dollar-Yen at 105 and closed Q1 above 103. At the height of recent Russian-Ukrainian tensions, the Yen stayed above 100, a psychological lift for the optimists!
Emerging Markets
Especially the equity side, Emerging Markets (EM) opened the year under investors’ microscopes, and remained there through much of the quarter. However, by the end of March, sentiment had turned from extreme bearishness to something more neutral, with regional pockets benefiting from inflows over the latter-end of Q1. The early stages of the year saw a continuation of last year’s fallout. The general flow of funds away from the EM space very notable at year-end, did not abate, and accelerated in late January on concerns of a wider slowdown in China’s growth, and a pause in the U.S. economy, due at least partly to a tough winter.
The trifecta was complete when Ukraine became headline news. However, along the way, investors began to separate noise from truth, especially after observing the markets better than expected response to the political crisis. EM equities witnessed a sharp drop in late January, and much less of a decline in March. The 8% drop in the broad-based index in January/February was not nearly matched after the increase of political escalations in Ukraine in early-March. That may have been a signal that EM equities had been oversold, and the fundamentals warranted another look after a long stretch, dating back to the first-half of last year, where weaker local currencies, and higher inflation needed higher interest rates from central banks.
The decline in EM valuations may be at an end, or at least closer to the end. The test in Q2 will be if fund flows turn and become positive or stay defensive. So far, most of the inflows and bounce has been based on short-covering of positions, the trick to any meaningful and lasting recovery is to turn sentiment enough to begin to see real inflows into the emerging market space. That script remains to be written.
We closed Q1 with a basket of EM currencies holding their own in general terms, with a few winners and losers. On the scorecard, the Brazilian Real and Indian Rupee did well, the Turkish Lira and Mexico’s Peso stabilized after rocky starts, while on the other side of the ledger were Russia’s Ruble (expected) and China’s Yuan (unexpected).
