As the first day of the quarter brings new money and new hope for global asset allocators, Credit Suisse has shifted to a more negative 'underweight' stance to European equities. Laying out 10 reasons for their displeasure, they dig into the details a little with a positive view on domestic German equities and the broad DAX index (and USD earners) while notably negative on France and Spain in general (with Spain expected to underperform Italy). Varying from too much complacency on the resolution to the crisis, to political flash points, valuations, and relative economic momentum. This smorgasbord of anxiety-inducing 'facts' may well prove enough to topple the 'fiction' of a liquidity-levitated equity market - that credit seems to have already realized. Most notably the five factors that need to be 'fixed' before the Euro crisis is resolved, and the under-estimation of the de-leveraging required in the periphery, leaves mutualization of debt as the game-changer that still seems a long-way off.
Credit Suisse Macro Call
1. Earnings momentum is now the worst of the major regions.
One-month Continental Europe's relative earnings momentum has turned clearly negative again:
2. Relative economic momentum is beginning to roll over, earlier than expected.
The European PMIs have dipped; PMIs currently are consistent with year-on-year GDP growth of 0% and this is before fiscal tightening, which is c2% of GDP, and before the required wage deflation in the periphery to regain competitiveness (which on the current exchange rate, we still think is 5% to 13% over the next five years and thus a couple of percent a year)
3. Europe has slipped to close to the bottom on our regional scorecard.
4. The strength of the euro continues to be a problem.
5. Euro crisis tends to start when global macro momentum peaks.
6. Too much complacency on the resolution of the crisis?
There are, in our view, five factors that need to be sorted out before the Euro crisis is resolved. We have slipped a bit from 40% resolution to 35%:
(1) A return to reasonable growth (very unlikely);
(2) A current account balance in the periphery (not seen apart from Ireland);
(3) The solvency of the insolvent (i.e., Portugal, Greece);
(4) A ring fence for the solvent (i.e., Italy and Spain); and
(5) If these four factors are not sorted out, then mutualization of debt works, as the primary budget deficit is just one-quarter of US levels. (unlikely)
In particular, what is being under-estimated: the deleveraging required in parts of the periphery
And compared to the US and UK, Spain is notably lagging in its deleveraging:
7. Politics – we are getting closer to flash points.
France: There are some major concerns: Francois Hollande (who still looks like the most likely winner based on polls) wants to cut the retirement age to 60 (for workers that have worked for the full entitlement period), to introduce €20bn of new spending measures, to renegotiate the fiscal compact, and to “re-orientate” the ECB.
Furthermore, after the parliamentary elections in the summer, the Left could be in charge of c80% of the regions, the parliament, and the presidency. We believe, though, that just as we saw in Ireland and in Spain, the rhetoric would likely be significantly watered down once Hollande came to power. Furthermore, Hollande has committed to stick to Sarkozy’s fiscal targets.
Nevertheless, with government spending at 57% of GDP and France last running a budget surplus in 1974, it seems quite possible that bond markets could be part of the disciplining process, with 66% of French government bonds owned by foreigners. The microeconomic aspects of a Socialist administration are worrying: it would be hard to see major de-regulation (indeed it was the Socialists who introduced the 35-hour week), the corporate tax rate would likely be raised and our banks team estimates that Socialist policies could take around 10% off banks earnings.
The Netherlands: The Socialist Party on some polls is now the most popular party in the Netherlands. It has taken an uncompromising stance against government cuts and euro zone bailouts (and even opposed joining the euro in 2000). Currently, the pro-euro liberals are forming a minority government (with the single vote majority lost last week). The Netherlands Bureau for Economic Policy Analysis expects the Dutch budget deficit to come in at 4.5% of GDP for 2012 and 2013. This exceeds the 3% euro zone limit and will likely result in further austerity measures at a time when GDP growth has just started to contract again. Negotiations of deficit reductions could put further pressure on the already strained relations between the different parties supporting the minority government, with Mr Wilders giving the coalition only a “50-50” chance of staying together (FT, 1 March 2012). Mark Rutte, the Liberal prime minister, said talks would last three weeks; however, the deadline came and went last Monday and the coalition is still divided on several issues, including housing market (limiting mortgage tax deductibility), cutting unemployment benefits, and reforming the labor market and the healthcare system.
If The Netherlands fails to implement the fiscal tightening, then it raises the risk that other members of the euro could follow the Dutch lead.
Greek elections: Greek elections are likely to be held on 6 May, according to the Greek newspaper, Kathimerini, with a coalition between PASOK and New Democracy (and perhaps more parties) the most likely outcome. However, the two largest parties are reported to have little common ground on policy, with recent disagreements on tax and public sector employment.
8. ECB: fundamentally dovish, but we are a little worried that the ECB has begun to tighten collateral requirements and about disagreements between Draghi and the head of the Bundesbank.
9. Valuations: cheap on trend earnings and P/B but not on actual earnings.
10. Some risk indicators in Europe appear to have overshot (credit spreads)
The complacency angle seems the most relevant to us - and we see equities once again pull away from any sense of reason indicated by the sovereign, financial, and corporate credit market, this complacency becomes more and more dangerous.