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…

France Risks Upsetting Eurozone Calm…

27th November 2013

“Throughout the country we have come to the same conclusion – of a society rife with tension, exasperation and anger. There is a sense of despondency.” French regional prefects, in an unusually alarmist report to Paris

It’s notable how many notorious and dogmatic bears have capitulated in recent weeks, from hedge fund manager Hugh Hendry of Eclectica (a prominent proponent of the China hard landing thesis) to CNBC fixture Marc Faber (of Austrian school Fed hyperinflation/gold bug fame) and at the more credible and nuanced end of the guru spectrum, Jeremy Grantham of asset manager GMO. Having largely missed the huge rally in risk assets since 2009, all have more or less recanted on the basis that you can’t fight the flood of global central bank liquidity.  Grantham for instance now sees global equities rising another 20-30% over the next year or two. So what could throw a rock in this pond of complacency? Political risk is rising globally as QE driven asset inflation exacerbates underlying inequality trends and drives social polarization from the US to Thailand. France is worth watching closely on this score; while long delayed spending cuts amounting to about €60bn are set to hit most public sector employees in coming months, we can safely assume that the overtime bill for the notorious CRS riot police will be well over budget as they attempt to suppress a growing backlash on the streets against perceived excessive immigration and deteriorating living standards.

The French are accustomed to an all-powerful and intrusive bureaucracy and almost monarchical executive, the broad structure of which hasn’t changed since Napoleonic times, but they expect their Presidents to at least project French flair and virility, not become a global laughing stock. Francois Hollande’s provincial mediocrity and innumerable political U-turns have earned him the moniker ‘Flanby,’ after a wobbly Nestle dessert brand, creating a political vacuum which the far-right National Front is seeking to fill amid growing talk of the end of the Gaullist Fifth Republic. While Italy has finally rid itself of Berlusconi and the New Dawn proto fascists have been sidelined in Greece, a febrile political mood is taking hold in France. The country has been in inexorable decline since the 1990s on just about every economic metric from productivity to government debt and trend growth has been a dire 1.2%, just above Italy’s; a tipping point may be looming in terms of investor perceptions in 2014.

The usual French ritual of noisy street protests by farmers, fishermen, teachers or some other interest group protecting their privileges until they force a government climb down simply can’t play out any longer, given the EU pressure on Paris to belatedly meet its 3% deficit target and we could well see a large portion of the lower middle classes in open revolt next year. The central bank asset reflation experiment since 2009 has exacerbated wealth inequalities globally, but it is a particularly contentious issue in a country with egalitarian pretensions as a key part of its identity, set against the backdrop of a sclerotic economy and the most centralized state administration aside from China and Russia.

Taxes have risen by about 3 percentage points of GDP in the past three years, taking the overall tax burden to 46% of national income and the spending cuts  will antagonize a volatile national mood. A recent report by the OECD said there had been “no significant improvement” in France’s diminished competitive position since the financial crisis of 2008. France has swung from a trade surplus until 2004 to a deficit of about 2% of GDP (versus Germany’s 6% plus surplus). The EU and the OECD have called on the government to take more radical steps to cut the enormous public spending bill at almost 57% of GDP. Unemployment is over 11% versus just over 5% in Germany, but youth unemployment is on a par with Spain at almost 27%. Betting on a widening spread on OATS over Bunds hasn’t paid off this year, despite another credit downgrade and the government debt ratio exceeding 95% of GDP, but is a trade worth revisiting in early 2014.

The French economy unexpectedly contracted in Q3, there is no respite in Q4; the Markit composite PMI fell two points to a five-month low of 48.5 in November. Against that economic backdrop, the National Front’s populist mixture of anti-immigration, anti-EU and anti-austerity policies is gaining traction and echoes the platform of other far right wing parties emerging from the UK (UKIP) to the Netherlands (PVV),who may form a powerful ‘rejectionist’ bloc in the next European parliament, and thus resuscitate EMU sustainability fears among global investors.