Europe looks cheap if the ECB pulls out the unlimited backstop bazooka
Despite my increased pessimism on Europe, it is clear that European equities are undervalued compared to the US. My call at the beginning of the year was for European equities to outperform because of relative value vis-a-vis the United States. At the time, I believed European policy makers would be forced to monetise for fear of the euro breaking up. But as European policy errors have mounted, that trade has gone a bit pear-shaped. The US has outperformed thus far.
Nonetheless, I think this trade still has merit. Last month I also noted that famed investors Jeremy Grantham and Marc Faber suggested legging into Europe as values begin to proliferate for the same reasons. Moreover, I also believe rotation out of the US should start right about now because US corporate earnings are beginning to fall.
In Europe, Mario Draghi’s comments about the ECB doing “whatever it takes” are irrelevant unless he can insure that the ECB provides an "unlimited" backstop, which he has not done. However, evidence that he may be able to do so despite German opposition comes from Ambrose Evans-Pritchard’s commentary at the Telegraph.
Tactically, he has pulled off a master-stroke.
The Bundesbank‘s Jens Weidmann is isolated. The Dutch and Finnish governors backed the Draghi plan. So did Germany’s member on the ECB’s executive board, Jörg Asmussen. The Kanzleramt has lost patience with the ideological preening of the Bundesbank.
Mr Draghi has secured a mandate for "unlimited open-market operations", a far cry from the half-hearted and self-defeating bond purchases of the last two years. The ECB at last has a licence to act with overwhelming force, like the US Federal Reserve.
The Governing Council has formally stated that "convertibility risk" — ie, euro break-up risk — is playing havoc with monetary policy, pushing Club Med debt costs out of control.
The term is crucial. Italy and Spain are deemed victims of forces beyond their control. Action by the ECB no longer constitutes a "fiscal rescue". The `no bail-out’ clause of the Maastricht Treaty has been elegantly finessed.
Markets may dislike the complexities of this. They should not misjudge the radical shift in policy that has occurred.
Italy’s premier Mario Monti — working in tandem with Mr Draghi — has worked assiduously on a parallel track, touring Nordic capitals collecting affidavits from hardline leaders. Each has grudgingly agreed that markets are unfairly punishing the victim states.
The two Italians have locked down every resister one by one. Whether you like it or not, the performance are masterful. Venetian diplomacy lives yet.
Mr Monti has left little doubt that Italy will activate the rescue machinery once his ducks are in a row, though it must rankle deeply. His country has a "primary surplus", the best fiscal profile in the G7, and its second-lowest aggregate debt (260pc of GDP).
First he must persuade Spain’s Mariano Rajoy to commit a humiliating U-turn, request a bail-out, and fall on his sword.
Mr Rajoy has already shifted ground. A sovereign rescue was out of the question a week ago. By Friday he was haggling about the price. " We don’t know exactly what is being planned. I want to know what these measures are. Then I will take the best decision in the interest of the Spanish people," he said.
In a nutshell, what Evans-Pritchard is suggesting is that Draghi’s failure to come through at the latest ECB meeting is part of a tactical plan which will mean unlimited liquidity for Spain and Italy as a quid pro quo for Memoranda of Understanding along the lines of the other periphery countries. If this is true, it would foster a massive rally in European shares.
Europe looks cheap if utter disaster is avoided
In short, the real significance of Draghi’s speech is that it was another step down the road towards full-blown QE for the eurozone. That’s very significant for investors.
Don’t get me wrong. QE is not a cure-all for Europe’s woes, just as it’s not a magic cure for Britain’s or America’s. It’ll bring its own set of problems.
But the point is that for now, most of Europe is priced for a much nastier outcome than that. The main thing keeping European stock markets much cheaper than the rest is the threat of a messy break-up for the eurozone. QE would make that scenario far less likely.
As Ben Inker of highly-respected US value investor GMO noted last month, eurozone equities (excluding financials) are “about 15% cheaper than fair value.” This “broadly [discounts] an ugly endgame for the region. If something less bad than that occurs, the stocks are at least mildly cheap.”
Watch what the ECB can do because the question has always been whether the ECB writes the check. That is the only key to the euro zone crisis. So far, the ECB has been unwilling to write the check because northern European governments have balked at their doing so. But that could be changing. If the ECB does write the check, you will see a powerful rally in European shares. if not, Europe will sink further into debt deflation. Take your bets.