Tuesday, October 8th, 2013

Quality Street

Early in Q3 we made the call that European equities (in particular the Eurozone) had fallen enough and that US investors should start to rebuild their positions in the region. At the time, there was little evidence of any recovery in the Eurozone economy outside Germany, and the UK had recently been advised by the IMF to relax its fiscal stance. By contrast, US growth was still robust and the dollar was riding high against most currencies.

Since then European equities have returned 14% in dollar terms (18% for the Eurozone) while the US is only up 4%. This is the first year since 2007 that there has not been some sort of financial or currency crisis in the Eurozone, and the reason is quite simple. You can’t have a crisis in the Eurozone without a German government. Even if you have a problem, you can’t have solution without the Germans, and if you can’t have a solution, there’s no point in having a crisis. This summer the German political class was pre-occupied with the Bundestag elections, and was not prepared to discuss the future of the currency with anyone – including the electorate. No news was good news; investors’ nerves were calmed and European equities went up. In the meantime our country models have offered some valuable insights into what has been driving European outperformance and how it is changing.

An investor who followed our advice in July would have seen that our top 10 markets (out of 43 countries ex US) included four from the core (Netherlands, Finland, France and Belgium) two from outside the Eurozone (UK & Switzerland) and only one from the periphery (Ireland). During the rest of July and August there was little change. Some weeks there were five countries from the core (Germany most of the time); sometimes there were three from the non-Eurobloc (guest appearances from Sweden and Denmark), but there was only ever one country from the periphery (Ireland).

In the middle of September this began to change quite quickly. As we write, there are five core countries in the top 10 (Finland, France, Netherlands, Germany, Austria) but four from the periphery (Ireland, Spain, Italy, Greece) and none from outside the zone. We believe that this represents a significant reduction in the quality of the European markets preferred by our country model – a sign that the rally in European equities is already mature and that investors are having to take more structural risk in order to maintain the momentum of performance.

This could continue for a few more weeks, but investors need to know that quality is being compromised. The portfolio is becoming more vulnerable to a shock from the next Eurozone crisis. We think the pendulum will start to swing away from Europe as soon as the new coalition cabinet in Germany is announced. Once this happens, it will be possible (and probably necessary) to have a Eurozone crisis again.

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