Notes from the road

Notes from the road

Posted on 29 September 2014
"We have been overweight euro zone equities based on two fundamental ideas: first, their equity valuations are attractive especially when compared to their US counterparts. Second, the catalyst that would make the market rise is a more proactive stance from the ECB."
I am in the first half of a two-week stay in London and, as I came into the City from Heathrow, I was struck by the level of building taking place. I am a habitual crane counter. Their presence is a striking representation of commercial activity and the attendant optimism and confidence that accompany any project taking more than a year to complete and even longer to plan and execute. I tallied 15 cranes in only a handful of minutes. Moreover, I counted another six cranes from the exceptionally narrow view offered by the window of my garret, and an additional 19 cranes from one side of my office in Canary Wharf. The construction landscape reminds me of one I observed in Dallas last year. Dallas is at the centre of the American energy renaissance, and London is the home of European banking and a host of other service industries.
A blurb in Tuesday’s newspaper caught my eye: British Land Company reported it sold a number of apartments in London’s Mayfair neighbourhood at an average value of £4750 per square foot. Many units were transacted above £5100 per square foot (approximately $8,340 per square foot at current exchange rates). To be sure, London’s Mayfair always has been an ultra-exclusive enclave: billionaires around the globe call it home. (It is also a place filled with interesting curios. While walking one evening, I encountered a rhinestone-encrusted Mercedes Benz. There’s no accounting for taste.) It’s worth noting, however, that over half the apartment buyers either are British or British based. Deducing the tone of the UK economy by West End real estate is not the exercise here. But the propensity to invest across this great city suggests that the broader growth the UK enjoys has solid footings. Recent business conditions, measured by the Markit UK Composite PMI Output Index, rose in August to an enviable 59.3. This is in line with a similar measure of US activity: the US Composite PMI Index stands at 57.9 as of September. The UK’s first half real GDP growth rate of 3%+ makes a strong case for the Bank of England to consider monetary normalisation well in advance of the Federal Reserve (Fed).
The picture developing within the euro zone, by contrast, is disappointing. The green shoots of economic activity on display earlier this year are wilting. The French economy has stalled, and its government is struggling to retain power. Conditions in Germany are mixed. The IFO Business Climate Survey declined again in September, continuing a slide that began in April. Both current conditions and expectations of future activity sub indexes continued their string of declines as well. Thankfully, readings on German output recently rose, remain firmly in expansionary territory, and offer hope that the principal economic engine on the Continent will not slip into recession. However, recent euro zone flash purchasing manager indexes suggest an economy that is growing but losing momentum. Considering the clutch of data above, and the recessing price levels within the euro zone, the European Central Bank’s (ECB) more aggressive approach to monetary policy is understandable. Even with a new round of money printing, there is no ‘pulling the rabbit out of the hat’ trick to be had.
Last week I had the pleasure of interviewing former Federal Reserve Governor, Larry Lindsey, for a client call in the United States. As a former Fed governor and member of the Federal Open Market Committee, Dr. Lindsey’s perspective is unique. He was at the table when interest rate decisions were made, and he served during a period in which the central bank unwound a program of easy money necessitated by a banking crisis and recession. He made the point that the real purpose of granting easy money through low interest rates or quantitative easing is to buy time for policymakers and the economy: time to heal; time for confidence to find a footing; and time to reform economies so they can become competitive again.
He is right. Central banks cannot create a company’s willingness to expand its labour force or engage in a program of capital investment. It can make money cheap and plentiful but it cannot, by fiat, make that capital get employed productively. This is a policy dance that needs a partner. In the case of the euro zone, governments have been, at best, reluctant and erratic partners. Germany is not willing to run deficits to sustain growth as labour reforms are enacted, and the government of Francois Hollande has been flailing for an organising principal to generate a modicum of growth. In short, euro zone policymakers need a fiscal program to assist its moribund economy and accompany the ECB’s lead.

The incredibly shrinking euro? 

A robust quantitative easing program will push the euro lower, which will help the export side of the economy, as growth in other parts of the globe helps cheaper imports from the currency bloc find a home. Calls for a dramatic drop in the currency have made headlines recently, but strike me as wishful thinking. To be sure, money printing that suppresses interest rates weighs on the currency. And the euro should be lower to provide cover for a program of reforms. But, unless the ECB opts to target a level for the euro – akin to what the Swiss National Bank did for the franc/euro rate – it’s hard to see how such a drop would occur. Even in the midst of its existential crisis in 2012, the euro only fell to 1.20 relative to the dollar. A decline again to this level would represent nearly a 14% drop from its 1.39 peak this year. German policymakers will not be willing participants in a currency that infuses inflationary pressures into its economy. Weak growth and higher inflation are a recipe for short careers.

Investment implications 

The investment implications for the current state of play are clear. We have been overweight euro zone equities based on two fundamental ideas: first, their equity valuations are attractive especially when compared to their US counterparts. Second, the catalyst that would make the market rise is a more proactive stance from the ECB. This is the policy we have been calling and hoping for, and it finally has arrived. It’s late in coming, but it’s here. The market has taken note; the Euro Stoxx 50 Index advanced more than 8% since early August. So far so good.
I am here for another week. I plan to spend the weekend getting to know the city a bit more, count more cranes, and discover what other cars are so creatively adorned. 
Hans Olsen, CFA Global Head of Investment Strategy

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