The strength of the euro and the policy response in reaction to this will be key in terms of the next stage of market returns in Europe, according to experts.
Two years on since Mario Draghi, president of the European Central Bank, pledged to do “whatever it takes” to safeguard the eurozone from collapse, the euro has been gradually strengthening against the dollar – and with it hindering the region’s competitiveness.
Disappointing first-quarter economic growth, at a lower than forecast 0.2 per cent, coupled with the threat of deflation, have caused the rebound in Europe to lose significant momentum.
Year-to-date the market has stuttered ahead by a mere 2 per cent, significantly below the 11 per cent achieved during the same period in 2013, according to data from FE Analytics.
James Sym, manager of the Schroder European Alpha Plus fund, said he “knew for a fact” Mr Draghi was worried about the strength of the euro.
“He is very concerned about the strength of the currency,” Mr Sym said, “as it is one of the biggest risks to the European economy.”
The manager said the euro was “unhelpfully strong” at present, but was “not inhibiting or preventing” a recovery. But “if the euro were sufficiently strong to derail the recovery then yes, it would have an impact”, he added.
“You have also got a ‘policy put’ because the stronger it gets the more action the ECB will take to prevent it.”
Kevin Lilley, manager of the Old Mutual European (ex-UK) Equity and European Equity funds, said given the ECB had already moved to make deposit rates negative, its next move would likely be a “QE-light” strategy later this year, which could involve buying up asset-backed securities.
The manager added the policies of other central banks would also be integral to European macroeconomics and the strength of its currency.
“If the Federal Reserve continues to taper its quantitative easing programme and interest rates start to rise, that will do half the work for the ECB, as it will drive up the dollar’s value,” he said.
However, Jeremy Batstone-Carr, director of private client research and investment strategy at Charles Stanley, was more worried about Mr Draghi’s ability to act if he needed to.
He said while he was sure Mr Draghi was an “extremely able economist” he felt the “correct policy options lie outside [the central banker’s] ambit and thus it is impossible for him to do ‘whatever it takes’.
“In the end we suspect that long after the Fed’s tapering turns to tightening and long after the Bank of England confirms the turn in the base-rate cycle, the ECB will be stuck with base rates near zero, anaemic credit growth, limited progress in terms of economic activity and persistently low inflation,” Mr Batstone-Carr added.
“We hope we’ll be proved wrong, but we suspect that we might be right. Recently the ECB Council’s Ewald Nowotny noted that ‘interest rates will turn as soon as there is clear growth, so more than 2 per cent, but from today’s perspective that will hardly be before 2016’.
“A more damning indictment of regional malaise on the part of a senior figure in authority we can hardly imagine.”
Elsewhere, both Mr Sym and Mr Lilley acknowledged much of the easy money had been made in European equities but argued further gains were plausible.
Mr Sym said what he would term the “crisis discount” had been closed out and that European equities were in a “normal valuation range”.
But he claimed investors could still make “outsized returns of 30-50 per cent in the next two years”.
“The reason I think that is because the earnings of European companies are incredibly depressed and are 30 per cent below where they were in 2008 on average,” he said.
The manager said his portfolio was focused on domestic cyclical stocks such as financials, industrial cyclicals and growth stocks. He said if these companies could earn even a fraction of what they did in their pre-crisis peak, this would be beneficial for his fund.
Mr Lilley said the market right now was in a “holding period”, having risen strongly in recent years, but that he hoped for stronger returns in 2015, if not earlier.
“That catalyst will be US and European growth,” he said.
“The US has a lot of catching up to do as a result of the harsh weather in the first quarter, and the European market will not rise if the US does not, given their high correlation.
“We could do with some earnings upgrades coming through, and we may well witness these arrive as the year progresses. While the US is trading at all-time highs, the European market and company profits in the region still have further to go – there is plenty of catch-up potential.”
Mr Lilley added he, too, favoured economically sensitive stocks, such as automotive companies.
Draghi’s key moves
The European Central Bank president has certainly made an impact since taking over the top policymaking role on the Continent in November 2011. He has been unable to ‘print money’ via quantitative easing like his counterparts in the UK and US, yet has still made a significant impact – largely through words.
Here are some key moments of Mr Draghi’s tenure:
March 2012
Greek debt restructure
The historic debt swap in Greece was described as “encouraging” for riskier investments at the time. By the March 8 deadline, investors holding 85.8 per cent of Greece’s private debt had agreed to participate in the country’s ¤206bn (£164bn) debt restructuring. The restructure reduced Greece’s debt burden, securing the government another EU bailout worth ¤130bn that headed off a total default in the country and a wider systemic risk.
July 2012
‘Do whatever it takes’
Those words, now virtually enshrined into every market participant’s psyche, had the effect of calming markets. The effect wasn’t instantaneous, but did lead to a steady decline in European countries’ borrowing costs, meaning bond yields for the so-called peripheral countries have fallen sharply. Spain’s 10-year bonds were yielding just 150 basis points above German bunds last week.
November 2013
‘Shock’ rate cut
Mario Draghi made a “shock” move to cut the main bank rate from 0.5 per cent to 0.25 per cent. The rate cut came as inflation across the eurozone had been tumbling, raising the prospect of deflation. The cut sparked a rally in European equity markets, with major indices in countries such as France and Germany rising by 1 per cent almost immediately, while the euro plummeted against other developed market currencies.
June 2014
Negative interest rate
With pressure mounting on Mr Draghi to stamp out deflationary forces, the central banker again flexed his policy muscles. Cutting the deposit rate to negative (-0.1 per cent) was a widely expected but still an extraordinary move. It means that banks are now effectively being charged for parking cash with the central bank – the aim being to encourage them to lend more money to businesses and individuals. Mr Draghi also created a ¤400bn (£318bn) programme to provide cheap loans to banks, again in a bid to get institutions lending.
