Don t Count Europe Out

Transcription

1 Economics Group Special Commentary Jay H. Bryson, Global Economist (74) Nathaniel Rosenbaum, Global Credit Strategist (212) E. Harry Pershing, Economic Analyst (74) Don t Count Europe Out Executive Summary Since the elections in November, global investors have rapidly switched gears to a vastly more optimistic glass half-full view of U.S. economic prospects under the incoming Trump administration. At the same time, most have preserved their preexisting diametrically opposite negative view on European prospects, anchored by concerns around the fragility of European banks as well as upcoming election flashpoints. We believe these opposing views on the two largest global economies are not easily reconcilable with the underlying economic realities of global trade and a competitive currency devaluation of the euro. As such, investors that believe the U.S. economy is at inflection point should be actively reconsidering their views on European assets as well and, by extension, the potential impact of a reversal of European flows into American assets (in this instance, U.S. corporate bonds). If the U.S. economy accelerates, corporate Europe could finally engage in substantial re-leveraging throughout 217 as we potentially approach the waning days of the ECB s quantitative easing (QE) program. This would have the following two major investment implications within the world of corporate credit: Re-leveraging corporates and recovering financials: A recovering Eurozone economy would bring about the potential for an end to the ECB s Corporate Security Purchase Programme (CSPP), which likely would spur a round of re-leveraging activity by European corporates. At the same time, a steeper sovereign curve resulting from the shift in the ECB s Public Sector Purchase Programme (PSPP) toward front-end maturities should be positive for banks over time. As such, we would expect the spread between the two to normalize to pre-cspp levels when banks traded inside of non-financials. A slowing and potential reversal of European demand for U.S. credit: If our Eurozone recovery scenario materializes in H2 217, the ECB could signal an end to its aforementioned QE programs, which could lead to stabilization and potential appreciation of the euro. In that event, we could see a sharp pullback or even a reversal in European demand for U.S. corporate bonds. Past performance and current hedge costs have created an environment where European investors are significantly under-hedged on their U.S. bond portfolios and, therefore, highly exposed to a currency reversal. We believe these opposing views on the two largest economies are not easily reconcilable. This report is available on wellsfargo.com/economics and on Bloomberg WFRE.

2 American banks have outperformed European banks by nearly 175 percent since 21. Why Is the Eurozone Underappreciated? Many investors seem to have a chronically pessimistic assessment of the Eurozone economy, at least when compared to its American counterpart. The most notable measure of this divergence is in equity market performance over the past several years. European equities (proxied by the Euro Stoxx 6 index) have risen just 25 percent on balance since 21 versus percent for U.S. equities (proxied by the S&P 5 index) over the same period. More notably, banks, which are arguably one of the sectors most highly levered to overall growth prospects, have diverged even more significantly, with American banks outperforming European banks by nearly 175 percent since 21. Figure 1: Equity Performance Divergence Equity Performance Cumulative Percent Change Since Jan 21 S&P 5 Euro Stoxx 26.1% S&P 5 Banks Sub-Index 126. Euro Stoxx Banks Sub-Index -45.6% Figure 2: Correlated GDPs 8% 6% 2% Real GDP Year-over-Year Percent Change 8% 6% 2% 5 5-2% -2% % U.S. GDP: 1.7% Eurozone GDP: 1.6% -8% % -8% Source: Bloomberg LP, IHS Global Insight and Wells Fargo Securities Positive correlation exists between real U.S. GDP and Eurozone GDP. There are some good reasons for this relative underperformance of European stocks. For starters, the Eurozone has generally grown slower than the U.S. economy in this cycle (Figure 2). Since bottoming in mid-29, real GDP in the United States has grown more than 16 percent. The Eurozone economy has expanded only 8 percent. However, there is an interesting regularity that is evident in Figure 2. Outside of , when repeated bouts of the European sovereign debt crisis was wreaking havoc on some European economies, real GDP growth rates in the United States and the overall euro area have tended to be fairly correlated over the past two decades. The U.S. stock market has risen sharply and bond yields have backed up markedly since the U.S. election in November. Many investors seem to believe that fiscal policy will turn more stimulative when the incoming Trump administration takes office, thereby boosting U.S. economic growth in the next few years. In that event, it seems reasonable that output in the Eurozone would accelerate as well if the positive correlation between real GDP growth rates in the United States and the euro area continues to hold. However, the consensus forecast looks for real GDP growth in the Eurozone to remain essentially unchanged at roughly 1.5 percent per annum in both 217 and 218. Looking toward sentiment and expectations, the financial markets appear to be pricing a continuation and perhaps even accentuation of the aforementioned divergence between U.S. and European markets, despite a substantial boost to bullish sentiment toward American markets since the U.S. election in November. In other words, the market s view of U.S. prospects has improved dramatically over the past two months, whereas Eurozone sentiment and expectations have remained steady (Figure 3 and Figure 4). Thus, the question for investors is whether this growing gap in expectations is justified or could the Eurozone economy beat expectations in the next few years? As we detail below, we believe the odds currently favor the latter scenario. 2

3 Change in Year-over-Year Growth Rate Don't Count Europe Out Figure 3: Divergence Expected to Widen European Investor Survey Points ZEW Survey - Expectation of U.S. Growth: 45.6 ZEW Survey - Expectation of Eurozone Growth: Figure 4: Forecasts Reflect Same Trend 3 2 Concensus Growth Forecasts Percent Growth Year-over-Year EuroStoxx Sales S&P5 Sales EuroStoxx EBITDA S&P5 EBITDA Jan-15 May-15 Sep-15 Jan-16 May-16 Sep Source: Bloomberg LP, IHS Global Insight and Wells Fargo Securities A Rising American Tide Lifts European Boats There are some reasons to be more optimistic than the consensus regarding the growth outlook in the euro area. First, the Eurozone economy likely would benefit from stronger real GDP growth in the United States should American fiscal policy turn more stimulative, as many investors seem to believe, over the next few years. The Eurozone sends about 15 percent of its exports, which is equivalent to 3 percent of its GDP, to the United States. In terms of products, chemicals account for nearly 25 percent of the exports that the Eurozone sends to the United States, with transportation equipment (i.e., automobiles and parts, and aircraft and parts) a close second at 2 percent and machinery in third place with a 12 percent share. These industries tend to be fairly cyclical, so stronger economic growth in the United States should lift overall export growth in the Eurozone. This supposition is supported by analysis we performed a few years ago. Specifically, we found that a one percentage point increase in the year-over-year real GDP growth rate in the United States is associated with real GDP growth in the euro area strengthening by roughly.7 percentage points after three quarters (Figure 5). 1 The boost to Eurozone GDP growth then begins to dissipate, but it generally remains positive through eight quarters. The Eurozone sends 15 percent of its exports, which is equal to 3 percent of its GDP, to the U.S. Figure 5: Boost in GDP Growth Effect on Eurozone GDP Growth From One Percetage Point Increase in U.S. GDP Growth 95 Percent Confidence Interval Point Estimate Figure 6: Export Price Competitiveness Euro Real Effective Exchange Rate Index: 21 = REER: Quarters See Is U.S. Growth Sensitive to Foreign Growth? (December 9, 213), which is available upon request. 3

4 Employment growth in the Eurozone, which is currently up, is highly correlated with growth in real disposable income. Furthermore, stronger growth in the world in general over the next two years, should it transpire, likely would help to boost the European economy because our analysis confirms there is a high degree of correlation between growth in global industrial production (IP) and IP growth in the euro area. In addition, the Eurozone s exports of goods and services should benefit from the 1 percent decline over the past two years in the real trade-weighted value of the euro, which has improved their price competitiveness (Figure 6). In that regard, the euro is currently hovering near a 14-year low versus the greenback. Growth in Domestic Demand Could Surprise to the Upside Stimulus to the Eurozone economy via stronger export growth should have positive spillover effects on domestic demand. Employment in the overall euro area is currently up more than 1 percent, the strongest rate of year-over-year growth since the advent of the global financial crisis (Figure 7). Employment growth is highly correlated with growth in real disposable income. If employment growth remains solid, let alone if it should strengthen further, then growth in personal consumption expenditures (PCE) should continue to improve. There is even some upside potential to real PCE growth from spending on autos. As shown in Figure 8, registrations for new automobiles have trended higher over the past few years, but they remain well below their run-rate of the past decade. In other words, there still appears to be pent-up demand for auto sales in the euro area. Figure 7: Employment Growth Healthy 3% Income Indicators in the Eurozone Year-over-Year Percent Change Employment: Q3 1.2% Real Disposable Income: Q4 1.8% 3% Figure 8: Pent-up Demand for Auto Sales 18M 16M Auto Registrations 12 Month Moving Sum Auto Registrations: 1.4M 18M 16M 2% 2% 14M 14M 1% 1% 12M 12M 1M 1M -1% -1% 8M 8M -2% -2% 6M 6M -3% % 4M 4M Source: IHS Global Insight, Bloomberg LP and Wells Fargo Securities A significant increase in corporate leverage in the Eurozone, should it occur, would be another indication that a recovery in the euro area is under way. Growth in business fixed investment spending has picked up since the end of the European sovereign debt crisis, but there appears to be the potential for further upside (Figure 9). According to the accelerator model of investment spending, growth in capex tends to lag growth in real GDP and the former also tends to be more volatile than the latter. If acceleration in exports and real PCE leads to stronger GDP growth, then investment spending should accelerate as well, thereby lifting real GDP even further. A significant increase in corporate leverage in the Eurozone, should it occur, would be another indication that a recovery in the euro area is under way. The ratio of public market investment grade (IG) corporate debt to GDP in the Eurozone really has not risen over the past few years, unlike the U.S. ratio, which has trended higher (Figure 1). While the Eurozone has typically relied more on private leverage in the past, we believe the ECB s CSPP program could enable corporates to re-lever further in the public debt market, especially if corporates come to the realization that the program may end sooner than they thought. 4

5 Figure 9: Upside Potential for BFI 2 Investment Indicators in Eurozone Year-over-Year Percent Change GDP: Q3 1.7% Investment by the NFC Sector: Q4 5.1% 2 Figure 1: Eurozone Has Not Relevered Yet 2 IG Nonfinancial Debt as Percent of GDP USD IG Nonfin Debt as % of US GDP: 17. EUR IG Nonfin Debt as % of Eurozone GDP: 8.2% % 16% 12% 12% % 8% ECB Still Stepping on the Accelerator After extending its QE programs last month until at least December 217, the ECB looks set to remain in an accommodative mode for the foreseeable future even as the Fed continues to adopt a more hawkish bias. This divergence in monetary policy stances is the key driver behind the aforementioned depreciation of the euro, which we believe could be a positive economic catalyst for the Eurozone in 217. With the ECB currently holding assets worth 34 percent of Eurozone GDP (Figure 11), the relative size of the ECB s balance sheet is finally above 212 levels, which proved effective at staving off the Eurozone sovereign debt crisis and jumpstarting the economy out of recession in 213. Moreover, the ECB recently tweaked its maturity guidelines and made other technical changes for sovereign bond purchases, which should result in a steeper curve and, by extension, a more favorable environment for European banks. Divergence in monetary policy stances between the ECB and the Fed is the key driver behind the depreciation of the euro. Figure 11: Swelling Ratio 4 3 ECB Balance Sheet versus GDP Assets as Percent of GDP ECB Assets as a Percent of Eurozone GDP: 33.7% 4 3 Figure 12: Slimming Ratio 4 3 Fed Balance Sheet versus GDP Assets in Billions as Percent of GDP Fed Assets as a Percent of US GDP: In addition, 217 will be the first full year in which the ECB s CSPP is in effect, which could fuel animal spirits within the European corporate sector if corporates begin to think the program may in fact come to an end in December 217. This last point is crucial to our thesis as any mere speculation in the second half of 217 that the ECB is eyeing an end to its QE programs could lead to higher rates and also entail some risk of a reversal higher for the euro, which would have far reaching consequences for credit markets as discussed in more detailed subsequently. In sum, the Eurozone economy could outperform the consensus forecast of roughly 1.5 percent real GDP The ECB s accommodative monetary policy could fuel animal spirits within the European corporate sector. 5

6 Central bankers and government policymakers appear to be on the same page in terms of providing liquidity to preserve depositor confidence. A hard Brexit would likely have negative economic spillover effects upon the Eurozone. growth in both 217 and 218. However, a return to 3 percent or higher per annum growth, which the euro area was able to achieve at the end of the last two business cycles, seems to be a stretch. Risks to Our Scenario While we believe financial markets are underappreciating the prospect of acceleration in economic activity in the euro area, there are few factors that could prolong the divergence between the American and Eurozone economies. Namely the following: - Banking sector confidence: A crisis of confidence in the European banking sector would of course weigh heavily on the Eurozone, and investors have sufficient reason to be skittish at the moment. However, we think one need look no further than the latest episode involving an Italian bank (Banca Monte dei Paschi di Siena) to see that central bankers and government policymakers appear to be on the same page in terms of providing liquidity and capital as needed to preserve viability and depositor confidence. In the admittedly unlikely event these two groups of authorities finally agree on a EUwide bad bank to clean up balance sheets once and for all much the same way the Resolution Trust Corporation sold off assets from failed savings and loan associations in the United States in the early 199s banking sector confidence could in fact improve dramatically. - Populist politics: Elections are around the corner in the Netherlands (March 15 th ), France (April 23 rd ), Germany (September-October 217) and perhaps Italy. Populist fervor has gained momentum in many corners of Europe, with some candidates calling for exit from the Eurozone and/or the EU. While 216 has taught us that predicting an election outcome could be a fool s errand, our sense is that populist fervor is directed primarily at lackluster growth and security concerns more so than the concept of European economic and monetary unity, which the EU and Eurozone have spearheaded. Thus, we are hesitant to directly equate populist fervor with a high probability of a core member of the EU choosing to exit. - Hard Brexit: 217 will likely end up being the year when Brexit makes the rough transition from a theoretical concept to facts on the ground as to how the United Kingdom will relate to the EU on trade issues going forward. It is too early to eliminate the possibility of a hard Brexit where the United Kingdom would be completely outside the single market. Hard Brexit likely would weigh on confidence and economic growth in the United Kingdom, and the Eurozone probably would suffer some collateral damage as well. Recent rhetoric by British Prime Minister May has raised the probability that the United Kingdom may be willing to leave the single market in order to regain unilateral control over regulatory and immigration policy. Investment Implications We see two primary takeaways for credit investors on either side of the Atlantic should our scenario of Eurozone economic outperformance materialize. Euro credit: Re-leveraging corporates and recovering financials: A recovering Eurozone economy bringing about the potential for an end to ECB CSPP would likely spur a round of re-leveraging activity by European corporates. At the same time, a steeper sovereign curve resulting from the ECB s PSPP shift toward front-end maturities should be positive for banks over time. As such, we would expect the spread between the two to normalize to pre-cspp levels when banks traded inside of non-financials (Figure 13). An additional driver of this compression could be buoyant M&A activity spurred by euro depreciation, wherein companies outside of the EU attempt to buy EU companies at an attractive FX-adjusted price while perhaps also gaining access to cheap CSPP funding if they are able to issue through a Eurozone entity (for example, the ongoing merger of equals acquisition of German chemical company Linde by U.S. rival Praxair). In fact, this type of activity hit a new record in Q4 216 (Figure 14). 6

7 Figure 13: Atypical Relationship Financials versus CSPP Spreads Option-Adjusted Spread (OAS) CSPP OAS: 92.9 EUR Fins OAS: Figure 14: Buying Spree? 16B 14B Cross-border M&A: Eu Co. by non-eu Co. In Billions of Euros Cross-border M&A: Eu Co. by non-eu Co: 139.9B Four Quarter Moving Average: 75.2B 16B 14B B 12B B 8B B 8B 9 9 6B 6B 8 8 4B 4B 7 7 2B 2B 6 Sep-13 Mar-14 Sep-14 Mar-15 Sep-15 Mar-16 Sep-16 6 B B U.S. credit: A reversal of European demand: Foreign buying of U.S. credit has been a key, and growing, source of demand ever since the taper tantrum set in motion increasing divergence between U.S. and foreign monetary policies and thus created the conditions for the ongoing reach for yield into U.S. credit by foreign investors, particularly out of the Eurozone (Figure 15). Data from the U.S. Treasury Department (see the Treasury International Capital (TIC) database) show that a majority of foreign-held U.S. corporate bonds are currently held in the Eurozone, propelled higher by the ever increasing yield gap between European and U.S. corporates (Figure 16). Data show that a majority of foreign-held U.S. corporate bonds are currently held in the Eurozone. Figure 15: Eurozone Buying Sharply Higher $1,55B $1,45B Eurozone Holdings of US Corporates In Billions of Dollars Eurozone holdings of US Corporates: $1,446.6B $1,55B $1,45B Figure 16: Key Driver of Eurozone Buying 3 25 Yield Pickup EUR IG Corps to USD IG Corps Basis Points (bps) Yield Pickup EUR IG Corps to USD IG Corps: bps 3 25 $1,35B $1,35B 2 2 $1,25B $1,25B $1,15B $1,15B $1,5B $1,5B 5 5 $95B $95B $85B $85B In our view, this demand is heavily accentuated by the ongoing devaluation of the euro which has made dollar-denominated fixed income assets increasingly attractive as foreign investors took a long term view on dollar strength following the taper tantrum. If our Eurozone recovery scenario materializes in H2 217, the ECB could signal that its QE programs will soon be coming to an end. In that event, the euro s decline could eventually come to an end versus the greenback, and we could see a sharp pullback or even a reversal in European demand for American corporate bonds due to the following two factors: - Hedging euro upside has been a losing trade: The euro has followed a downward trend versus the U.S. dollar for the past three years. Any portfolio manager that carried out typical 3- or 12-month rolling hedges has now significantly lagged their unhedged If our Eurozone recovery scenario materializes, the ECB could signal that its QE programs will soon be coming to an end. 7

8 peers (Figure 17). With most FX forecasts calling for continued euro depreciation in 217 and the yield gap between euro and dollar corporates at a record high (Figure 16 above), a good setup for 217 for an unhedged investor, we fear many cross-currency investors will prefer to not risk lagging again and, therefore, significantly reduce their euro hedges. - Hedging euro upside is now an expensive trade: The one-way nature of demand for dollar assets over the past three years has significantly increased the cost to hedge this exposure. Thus, the cost for European investors to hedge their U.S. corporate bond portfolio has gone up much more than the yield on the asset class (Figure 18). Figure 17: FX Hedging a Critical Factor 5 4 Cumulative Total Return for US IG Cumulative Percent Change Since Jan 213 US IG Total Return: 11.7% (USD) US IG Total Return: 4.2% (EUR) 5 4 Figure 18: Hedging Costs Taking a Bite U.S. Investment Grade Yields vs. FX Hedge Costs Percent EUR 1yr Forward Hedge Costs: 3. U.S. IG YTW: To prepare for rising Eurozone yields alongside a rising euro, we believe investors should focus on optimizing their cross-currency investments. We believe this has compelled European investors to either reduce the term of their hedges of their ratio in order to continue realizing the yield advantage of U.S. corporate bonds versus European corporate bonds. Combining these two factors of willingness and price, we believe one can surmise that European investors buying U.S. corporate bonds are significantly less hedged at present and going forward than they were when they started their buy programs in the wake of the taper tantrum. In our scenario of a European economic recovery, a possible risk outcome would be rising Eurozone yields alongside a rising euro. This would be a ruinous combination for an unhedged or underhedged European buyer of U.S. corporate bonds and therefore could eventually lead to net selling. To prepare for this risk, we believe investors should focus on optimizing their cross-currency investments. We believe Europe-domiciled investors need to be more selective in deploying capital into U.S. dollar-denominated credit by looking for exposures to high-quality issuers that cannot easily be replicated in the European corporate bond market. For issuers that trade in both markets, we highly recommend steering European bond exposure toward the front end, where a majority of European bonds trade wide to their U.S. dollar equivalents on a fully swapped basis and conversely focusing dollar risk further out the curve, past six years, where credit curves are steeper in dollars than in euros (Exhibit 19). 8

9 15 Figure 19: Steeper U.S. Credit Curve Matched Maturity FX Swapped Issuer Pairs Basis Points; X-Axis = Maturity in Years USD/EUR Bond Pairs (Same Issuer, Same Maturity) Source: Wells Fargo Securities 9

10 Wells Fargo Securities Economics Group Diane Schumaker-Krieg Global Head of Research, Economics & Strategy (74) (212) John E. Silvia, Ph.D. Chief Economist (74) Mark Vitner Senior Economist (74) Jay H. Bryson, Ph.D. Global Economist (74) Sam Bullard Senior Economist (74) Nick Bennenbroek Currency Strategist (212) Anika R. Khan Senior Economist (212) Eugenio J. Alemán, Ph.D. Senior Economist (74) Azhar Iqbal Econometrician (74) Tim Quinlan Senior Economist (74) Eric Viloria, CFA Currency Strategist (212) Sarah House Economist (74) Michael A. Brown Economist (74) Jamie Feik Economist (74) Erik Nelson Currency Analyst (212) Misa Batcheller Economic Analyst (74) Michael Pugliese Economic Analyst (74) Julianne Causey Economic Analyst (74) E. Harry Pershing Economic Analyst (74) Donna LaFleur Executive Assistant (74) Dawne Howes Administrative Assistant (74) Wells Fargo Securities Economics Group publications are produced by Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission, the Financial Industry Regulatory Authority, and the Securities Investor Protection Corp. Wells Fargo Securities, LLC, distributes these publications directly and through subsidiaries including, but not limited to, Wells Fargo & Company, Wells Fargo Bank N.A., Wells Fargo Advisors, LLC, Wells Fargo Securities International Limited, Wells Fargo Securities Asia Limited and Wells Fargo Securities (Japan) Co. Limited. Wells Fargo Securities, LLC. is registered with the Commodities Futures Trading Commission as a futures commission merchant and is a member in good standing of the National Futures Association. Wells Fargo Bank, N.A. is registered with the Commodities Futures Trading Commission as a swap dealer and is a member in good standing of the National Futures Association. Wells Fargo Securities, LLC. and Wells Fargo Bank, N.A. are generally engaged in the trading of futures and derivative products, any of which may be discussed within this publication. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm which includes, but is not limited to investment banking revenue. The information and opinions herein are for general information use only. Wells Fargo Securities, LLC does not guarantee their accuracy or completeness, nor does Wells Fargo Securities, LLC assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. Wells Fargo Securities, LLC is a separate legal entity and distinct from affiliated banks and is a wholly owned subsidiary of Wells Fargo & Company 217 Wells Fargo Securities, LLC. Important Information for Non-U.S. Recipients For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited ("WFSIL"). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. The content of this report has been approved by WFSIL a regulated person under the Act. For purposes of the U.K. Financial Conduct Authority s rules, this report constitutes impartial investment research. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 27. The FCA rules made under the Financial Services and Markets Act 2 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. This document and any other materials accompanying this document (collectively, the "Materials") are provided for general informational purposes only. SECURITIES: NOT FDIC-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE