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Why you should think twice about buying one of this year’s worst performing markets

26 November 2014

Though planned intervention by the ECB is seen by many as a buying opportunity in European equities, Goldman Sachs’ Andrew Wilson has a far more cautious view.

By Alex Paget,

Reporter, FE Trustnet

Investors are right to be concerned about the threat of eurozone-wide deflation, according to Goldman Sachs Asset Management’s Andrew Wilson, who says the European Central Bank (ECB) will find it very hard to pull the region out of the deflationary trap.

 

Due to various issues such as huge amounts of debt in the system and the restrictions of a centralised currency union, growth and inflation rates in the eurozone have been steadily falling so far in 2014.

 

This has translated into poor returns for equity investors as, according to FE Analytics, the average fund in the IMA Europe ex UK sector has returned just 1.22 per cent this year while the MSCI AC World index is up 12.15 per cent. On top of that, 30 per cent of funds in the sector have lost money year to date.

 

Performance of sector vs index in 2014

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Source: FE Analytics

 

As the ECB has announced plans to ramp up its efforts to stave of falling inflation and generate economic growth through numerous new monetary policy initiatives, many investors have been upping their exposure to Europe’s underperforming equity market.

 

While the consensual view is that ECB president Mario Draghi will do “whatever it takes” to save the debt-ridden economy and will therefore provide support for investors, Andrew Wilson – chief executive of Goldman Sachs Asset Management EMEA and global co-head of fixed income – says investors should remain very cautious.

 

“That threat of eurozone-wide deflation is real and it’s already happening in certain areas. It is a big threat and I think the concern for central banks around the world, but most pressingly for the ECB, is that when you get into that deflationary trap, it’s really hard to get out of it,” Wilson said.

 

“The so-called lost decade in Japan is what central banks are worried about. They know how to deal with higher inflation by higher interest rates, but once you get into a deflationary trap, it’s very hard to escape it.”

 

“Why is that so bad? Well, the only way you grow out of those very high debts to GDP levels is to have growth and have inflation. If you’re in a deflationary world, you are condemning yourself to turning into Japan.”


 

Due to deflationary pressures and an extremely strong yen, the Japanese economy has been in a so-called lost decade, which has meant investors in the country’s equity market have had a very unenjoyable ride over the longer term.

 

While the Nikkei and funds within IMA Japan sector have rebounded more recently on the back of Abenomics and various other factors – as the graph below shows – between 2000 and 2010 Japanese equities lost around 30 per cent. That compares to a 20 per cent rise in the MSCI AC World index.

 

Performance of sector vs indices since Jan 2000

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Source: FE Analytics

 

Inflation in the eurozone currently stands at 0.4 per cent. Wilson says the ECB is fully aware of Japan’s recent history and is therefore taking steps to avoid the threat of deflation.

 

The central bank has already pushed interest rates into negative territory, started to provide cheap finance to banks to stimulate lending growth and have begun buying up covered bonds and asset backed securities. However, Wilson says more action is needed.

 

“I think we should be worried [about deflation in the eurozone],” Wilson said.

 

“Our central case is that the ECB will end up doing sovereign QE. They are already doing QE by buying covered bonds and asset backed securities, but Mario Draghi has been very clear about trying to expand the balance sheet to €3trn.”

 

“They are at about €2trn at the moment, therefore they need to add another €1trn. Interestingly, the entire [European] asset backed market is €600bn so it’s impossible to get to this €3trn number even by buying all the ABS that exist.”

 

“They are hopeful that that market expands, but it’s unlikely that it get to that target of €3trn so I think we will see sovereign QE.  That’s simply because the threat of deflation is so real and it’s required to some extent.”

 

But a number of experts have been upping their exposure to European equities recently.

 

Jaisal Pastakia, investment manager at Heartwood Investment Management, is maintaining an overweight position in Europe as he thinks economic growth will pick up while the ECB continues to intervene. On top of that, he says valuations are very attractive.

 

“European equity is not a favoured trade and investors are generally underweight in Europe, which may provide a foundation for a share prices to recover,” Pastakia said.

 

“Full-year corporate earnings in 2014 are expected to be positive for the first time in four years. Furthermore, valuations in Europe remain attractive, especially relative to the US.  Value trades by their nature are slower to come right.”

 

“That’s why we’re sticking with our overweight position in Europe, positioned to capture a potential recovery in earnings, valuations and liquidity.”


 

However, Wilson says that as the “heart” of the eurozone crisis revolved around competitiveness issues – such as wage rates in the likes of France, Italy and Spain being allowed to reach very high levels in the boom years – the only way to capture back that competitiveness is to start to see wage rates decline.

 

He says this is already happening in places like Spain. However, he says investors are naïve to think the deflation can be easily avoided, and by extension buying on the back of optically cheap valuations, as it will take a long-time for genuine economic recovery to come through.

 

He is therefore relatively bearish on the eurozone.

 

“It took the best part of a decade for this competitiveness gap to open up and so it won’t close down in a year or so,” Wilson said.  

 

“I think those downward pressures on labour costs will take time so headline inflation will be under downward pressure and if you throw in much lower energy prices, that compounds the issue and makes it much more difficult for the ECB.”

 

 

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.