If a policy-driven turnaround in Europe’s biggest economy tempts the continent’s equity investors home, they may want to look to the bloc’s faster-growing and cheaper fringes.
Global investors are abuzz that the winners of this weekend’s elections in Germany may be in a position to finally loosen the country’s purse strings, given Germany’s struggling economy, US trade threats and Europe’s rapidly rising defense needs.
While the outcome of this weekend’s election is yet to be determined, German and European stocks have already reached record highs this year, far outpacing historically expensive Wall Street indexes. And the latest global investment surveys indicate that a transatlantic reallocation is indeed already well underway.
But even if Germany is the elephant in the room of European revival narrative, the rest of the continent’s economies may arguably benefit just as much from shifts in Berlin’s fiscal policy — especially those with companies that are potentially less directly exposed to a US trade war.
Spain’s $1.8 trillion economy grew by an annualized 3.5 per cent last year, for example, eclipsing the ‘exceptional’ United States by a full percentage point. And the $1.3 trillion Dutch economy wasn’t that far off ‘go-go’ America with a 2 per cent expansion.
Importantly, equity markets in many of these countries are not only far cheaper than Wall Street’s richly priced indexes, they’re often cheaper than Germany’s blue chip DAX index (.GDAX), meaning there is far more room for appreciation if European capital comes home.
SKIRTING ROUND THE EDGE
Strategists at Societe Generale this week made a case for chasing these peripheral euro markets alongside ‘cheaper’ segments of Germany’s equity universe, such as the mid-cap MDAX (.MDAXI).
Their models focus on equity risk premia (ERP), which measures the forward earnings yield on a country’s equity market against the 10-year ‘risk-free’ sovereign debt yield. With an ERP near 3 per cent, the US is far pricier than Europe as a whole, which offers roughly twice as much compensation for taking the punt.
SocGen’s team reckons the case for a transatlantic switch is well founded based on a host of potential fiscal and geopolitical triggers and extreme currency valuations to boot.
“The gap in equity risk premium between US and European equities is extreme,” they said, but added: “Counter-intuitively, the answer to more German spending is to buy assets in European periphery countries rather than in core Europe.”
While the model’s estimates for the German and French ERP come in at some 5-6 per cent, Portugal’s came in closer to 7 per cent, Italy and Spain at more than 8 per cent and Ireland about 11 per cent.
The French bank goes on to argue that a reform of the German ‘debt brake’ – in place since 2011 – could well cause European assets to close the wide and historically peculiar gap with American assets that has built up in recent years.
Even though German debt yields may rise in that scenario, sovereign spreads on peripheral euro government debt would likely compress, the bank argued. Indeed Italian 10-year government borrowing premia over Germany have already fallen to the lowest point in 3-1/2 years this month.
INSULATION
Another argument in the bank’s peripheral tale is vulnerability in a US trade war.
Germany’s DAX blue chips have one of the highest sensitivities to moves in the S&P 500, the SocGen team showed.
But equity indexes on the periphery – most notably Italy and Spain – have much less direct revenue exposure to US trade and a higher sensitivity to domestic European sectors such as financials, utilities and energy.
Seasoned investors have seen many European revival stories come and go. And much hinges on this weekend’s vote.
But with valuation gaps at extreme levels and potentially seismic policy and political triggers at the ready, the entire continent could well be on the receiving end of a massive capital shift.
