Tuesday, January 20th, 2015

Week of Destiny – Or Not

According to Angela Merkel, this is not a week of destiny for the euro. To be fair she was referring to the joint outcome of Greek elections and the ECB’s well-leaked QE programme. It is in her interests to keep the temperature surrounding the elections as cool as possible. But all the same, we wonder if anyone has briefed her on the scale and nature of the ECB’s proposals. Perhaps she reasons that it cannot be a week of destiny because the deal is structured so that there is no “credit risk” to Deutschland AG.

All will be revealed on Thursday. In the meantime let us review our models to see what investors think. The most obvious outcome of all the QE speculation is that the euro has weakened further against the dollar. This puts more downward pressure on US Treasury yields, which remain the favourite asset class in both our US dollar and euro-denominated asset allocation models. The euro is so weak that EM Bonds have overtaken German Bunds as the second-ranked asset in the euro-model. This may also indicate that the extreme weakness in EM currencies is over for the time being.

In our Eurozone government bond model, we observe that the whole of the periphery has lost ground. Ireland and Spain remain the top-ranked countries, but their lead over the rest of the region has halved in the last three weeks. Portugal, which was ranked #3, is now ranked #6. Italy has stabilised at #4 after losing a lot of ground at the beginning of the year, but it would only take a small relative decline to push it further down the ranking.

The countries which are doing well are the soft core of France, Belgium and Finland. These are all rated Neutral at present, but would be Overweight if we based our opinion just on the last quarter’s data – i.e. the front end of the probability curve. The decline in the ranking of the periphery coincides with the increasing number of leaks suggesting that there will be no mutualisation of credit risk – i.e. each national central bank will buy their own government’s bonds. It is therefore logical for investors to expect the benefits of QE to flow to the core not the periphery, but it is not, we think, what Mr Draghi intends.

In recent weeks we have developed a country-based model for Eurozone equities. Two of the current favourites are from the soft core, Belgium #1 and Finland #3, with France #5. The laggards are Greece #11, Portugal #10, and Austria #9. Austrian equities are particularly exposed to Eastern Europe and Russia, and therefore slightly outside the main theme. Treating them as an exception, allows us to move onto Italy at #8 and Spain at #7. Again, investors seem to believe there is no short-term or long-term benefit for the countries that QE is supposed to help.

And finally, we look at our Eurozone sector model. On most occasions when a central bank has promised or delivered QE, the local Financials sector has tended to outperform – not this time. Over the last three weeks, as the “no-mutualisation” leaks have gathered pace, the Eurozone Financials sector has fallen from #7 to #9 (out of 11) and has been downgraded from Neutral to Underweight. It was ranked #4 as recently as late October. If QE in its predicted form is not enough to make Financials outperform, the ECB should seriously think about redesigning it. The alternative may be a much more traumatic week of destiny for the euro – not now, but at some time in the not too distant future.

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