The European Investment Case – Carry Away

Europe + Japan = 1/3 World GDP

Both are targeting INFLATION with QE and zero to negative rates.

QE is a privilege reserved only for the world’s best <wink> because QE from a lesser central bank would be suicidal.

I have not seen too many firm calls on the EUR after the ECB last week. That is probably because the EUR’s strength, as demonstrated after the meeting, has dumbfounded many a strategist and I would find it hard to risk my career, if I were them, saying something that I would regret later.

I did a rough poll of friends in the business for their personal views on the reflation story over the weekend.

  • Equities will do better than fixed income as long as inflation rate is not in excess of 3-4%.
    Within equities, we have to find the sectors with the pricing power and sectors such as utilities are tightly regulated in some jurisdictions to prevent price increases.
  • Typical inflation hedges are inflation Iinked notes, commodities and real estate.
    Yet Europe has a myriad of regulatory roadblocks to enforce price controls. Inflation linked notes are also not the solution
  •  Inflation is supportive of gold.
  • Corporate debt is dicey because spreads have already tightened. We should expect a spate of new issuances as companies take opportunity of cheap funding.

My simple take of the situation is this.

We have cheap funding and cheaper funding to come, banks will be first beneficiaries. Bank failure will be remote and banks will be level on the playing field. Yet, awaiting us this Oct would be the ECB bank audit exercise foreshadowing the implementation of the SSM (Single Supervisory Mechanism) for just about 128 Eurozone banks and banking groups.

I would be bullish on banks, especially those disadvantaged periphery names that have been beaten down in the crisis, all trailing US names. A good example would be the recent deeply discounted Monte dei Paschi share sale.

However I note that Monte Paschi bonds have rallied quite a bit in the past 2 days, it would be safe to assume the stock would follow. It is good that credit spreads have all tightened since the ECB, because it really rules out the case for bonds.

European Reits have rallied, there is only stocks, gold, real estate and carry left.

I find carry trades the best value in the short term and did a rough list of the 3M interest rates of countries that would look exciting against the EUR’s 0.25%.

3m interest rates

EURTRY looks like a decent bet even as Turkey is widely expected to lower their interest rates as well. Within the developed world, EURAUD is a potentially safe carry trade, along with EURCAD and, for the adventurous, the EURNZD.

Yes. Draghi came and surprised and left the markets grasping in incomprehensible awe. Better not waste the gift he has given and waste our time thinking about the future damage he has wrought – the widening income gap and scenarios that will not happen in the next 3 months.