- There has been an extraordinary flight to safety within European equities over the last 12 months, but it has occurred without fanfare.
- This level of risk aversion is normally associated with a very high VIX index and near panic.
- This time it has occurred more slowly, with little comment.
This level of risk aversion can best be measured by the relative valuation of “strong defensives” vs “weak cyclicals” within European equities. In this case I am using the valuation of European consumer staples companies ** compared to the European banks index. Below we show the ratio of relative valuation in price to sales and price to book terms since 2003.
Historically, this degree of risk aversion has been followed by sharp degrees of outperformance for banks over staples, for value over growth and also the outperformance of European equities over US equities. The premium paid for defensiveness has only ever been this high twice before. In the summer of 2012 at the height of the Sovereign Debt Crisis and in late June 2016 in the days after Brexit.
Starting in the summer of 2012 banks outperformed staples by 100% in the following 22 months. After June 2016 banks outperformed by 55% in the following 15 months. European equities also outperformed US equities by double digit percentages in both cases in the following 12-18 months.
What is the cause of this valuation extreme?
The market is nervous that the European economy is slowing, and rightly considering that the existing monetary policy tool kit is exhausted. Today investors are not only pricing in a potential recession, but also one that may not end.
Why the absence of fanfare?
The absence of comment about this incredible valuation divergence may be the most important element. Part of the reason must reflect positioning. But there is also likely some behavioural psychology at work. Elizabeth Kübler-Ross’ five stages of grief can sometimes be helpful in identifying the psychology involved at the end of bear markets. Denial, Anger, Bargaining, Depression and Acceptance. It seems with European banks the market is at the acceptance stage. Valuations are going lower, discounts are getting wider, and it is attracting little interest or commentary. “This is just how it is”. Staples become more expensive, banks become cheaper, with no questions asked. We believe these are the conditions of major turning points.
What is the catalyst?
With valuations this extreme, it is fair to say that no catalyst is needed. Banks are now paying nearly 7% yields and are growing earnings c.5% per year at trough margins. From this perspective we are paid to wait. But investors are too negative about policy. Whilst European rate cuts cannot help and may even prove harmful, there is still one major policy tool left for Europe that should not be underestimated: fiscal stimulus backed by monetary policy. Whilst the political architecture is not yet in place to allow this today, it could be soon. This will mechanically lift growth, lift inflation and have the opposite impact on the yield curve that investors are used to. All monetary policy stimulus to date has flattened the yield curve, fiscal stimulus backed by monetary policy will steepen it.
We anticipate a very sharp snap back in favour of value over growth, of banks over staples, and quite likely, European equities over US equities over the coming twelve months.
Nestle, Unilever, Pernod Ricard, L’Oreal
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