Beware Macro Gurus, as European Equities Look Attractive…

I luxuriated in the polemics of Marc Faber and James Grant and Nassim Taleb, in our own country, Albert Edwards, et al. I luxuriated as they ranted and it was fine for them to rant. But I am charged with the responsibility of making money…’

Hugh Hendry, manager of the (shrinking) Eclectica hedge fund, in a recent interview

Hendry is infamous for his YouTube videos from Chinese ghost cities like Ordos and claiming back in 2012 that gold mining companies could be nationalized and physical gold confiscated as the gold price headed to $3,000/oz. He suffered a classic and expensive case of confirmation bias, the psychological tendency to search for and prioritize information in a way that confirms preconceived beliefs or hypotheses. I’ll always recall visiting Asia in mid-2012, just after macro ‘guru’ Raoul Pal had terrified fund managers at a Shanghai conference with wild eyed predictions that they had a few months left before the Eurozone collapsed and financial cataclysm struck. It was, as I explained at the time, a sensationalist analysis based on a misunderstanding of the power of central banks to offset private sector deleveraging via their balance sheets.

Indeed, many investors overlook the fact that macroeconomic pundits are largely tribal, with most adhering to a dogmatic world view from monetarism, the notion that the money supply is at least a leading indicator of aggregate demand (and even determines it) to the rather stern Austrian school of economics (think Marc Faber), and more specifically the dubious Austrian theory of the business cycle. However, investing on the basis of what ‘should’ happen by applying rigid intellectual preconceptions has hurt performance since 2009, given the crucial role of policy intervention and the structural demographic and technology shifts.

What has worked is taking an agnostic view of the incentives and constraints within that shifting policy framework, initially in the US and most recently in Japan and now Europe.. Meantime, a chastened Hendry now thinks that “…to bet against China or Chinese equities, or the Chinese currency is to bet against the omnipotence of central banks. One day that will be the right trade, just not ready or sure that that is the right trade today.”  Indeed, and China was an easy contrarian bullish call back in early Q1 along with GEM in general amid consensus panic. A key call for 2015 will be whether the relentless US equity outperformance of recent years (almost 90% since the 2009 lows versus both developed and emerging market indices) can be sustained and whether European equities can restore earnings momentum.

Even without any further ECB action (which the deflationary impact of the oil slump now makes inevitable), we could well see Eurozone growth in 2015 accelerate to say 1.5%, as modest bank credit growth resumes, the fiscal drag from austerity ends and broad M3 money supply growth remains supportive. Property markets are now recovering across the periphery (Irish housing is up 50% since the 2012 lows), allowing bank asset write backs.  Downside risks are underwritten by the ECB, which will ultimately overcome German misgivings with more forceful QE. Eurostoxx 600 positive earnings surprises are improving already, a function of the euro slide as well as a stabilization/modest improvement in consumer demand across the periphery. The USD rally is in one sense taking earnings growth from US companies in the traded goods sectors and transferring it to European and Japanese, while the net macro benefit of the oil crash is far larger for the latter.

Since March 2008 in USD terms, US equities have re-rated by 30% versus the MSCI ACWI while European have de-rated by almost 40%. Even allowing for the weighting of high revenue growth, global franchise tech stocks in US indices, this massive divergence between US and Eurozone equity performance is likely to at least partially mean revert over the next couple of years as the earnings gap closes (Eurostoxx earnings are still 40% below their pre-crisis peak in real terms, largely due to banks, who are 2-3 years behind US peers in  the credit growth and asset write-back cycle). The overall relative valuation case is nothing like as compelling as it was for Japanese stocks back in Q3 2012, when they were hugely underweighted in global portfolios setting the scene for the powerful rally that followed and an ECB policy shift has been well flagged, whereas the BOJ action stunned markets.

Nonetheless, recent survey evidence indicates that overweight positions held in Q2 have been sold down with current allocations on the BOAML institutional survey at a quarter of US levels while Japanese allocations are at their highest since 2006. While we still like US discretionary consumer exposure in retail, hospitality and travel as well as the potential for further tech sector re-rating, the prospect for overall earnings upside looks better in the Eurozone over the next 6-12mths. Financials, real estate and exporters look particularly attractive as bank credit growth turns modestly positive in coming quarters and the euro weakens further…