Persistently low inflation and a strong euro prompted ECB president Mario Draghi to drop strong hints on April 12 that Europe would require further monetary stimulus in the form of quantitative easing or mass asset buying. At 0.5 per cent, inflation is currently at a quarter of its 2 per cent target worrying policy makers and central bankers of the increasing threat of deflation derailing the fragile European recovery.
A large-scale purchase of bonds would give a boost to European inflation, weaken the euro and would also, unintentionally, provide a boon for both European equities and bond investors at least in the medium term, Connolly says.
“The indications are that much like in the US, ECB central bankers will do anything to support their economies,” he said.
“If there is quantitative easing taking place within Europe that will increase liquidity within wider European markets and that will mean more money is invested in risk assets such as equities.”
“It should also be a positive for equities globally, Europe certainly doesn’t react in isolation but you’d expect the biggest impact to be domestic European companies, especially in the mid and small cap space.”
From the experience of the US and UK economies through QE you can see that mid and smaller companies tend to benefit more through increased liquidity, he says.
“We’ve seen that but also the flipside is that when that liquidity is withdrawn it is mid and small caps that suffer the most, you can overperform on the way up but underperform on the way down.”
“It’s still hypothetical at the moment, we don’t know when, how or to what extent it is going to happen but broadly domestic European investments will benefit the most and so there is an argument to look at mid and small cap stocks.”
“However, there are no guarantees, this isn’t a one-way street, but broadly, if there is more liquidity pumped into European markets it should be positive for European equities and bond prices although it will be negative for bond yields.”
The positive effects of QE may even be felt even before a programme is affected, Connolly says.
“In reality markets move on sentiment so if there is an announcement on QE you can expect markets to rise in the short term before the action actually takes place.”
“It will then depend whether the actions are more or less vigorous than people expect them to be.”
However, he warns that whilst it may be positive for equities in the short term at some point the process will need to be tapered.
“The experience of the US and UK shows it is relatively easy to do QE and is positive for risk assets, so investors can benefit in the short or medium term, but the real challenge comes in how you unwind that position in the longer term.”
Robert Jukes, Global Strategist for Canaccord Wealth Management also says the upshot for investors in the event of a fresh stimulus programme will be particularly felt in small and mid-cap companies and funds that invest in them.
He expects European fund managers to tilt their own portfolios down the cap spectrum to benefit further from in the increased liquidity, as a consequence.
“There may also well be more mergers and acquisition activity of the back of that and it could spill over into the consumer sector too,” he said.
Connolly recommends two funds Henderson European Growth and JP Morgan European Dynamic as well-positioned to benefit from a fresh bout of QE in the Eurozone due to their mid cap exposure.
The £976m Henderson European Growth fund, co-managed by FE Alpha Manager Richard Pease and Simon Rowe, has returned 22.83 per cent over three years, according to FE Analytics.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
Over this three year period, which includes the 2011 eurozone crisis, the fund has consistently stayed ahead of both the IMA Europe ex UK sector average and its benchmark – the FTSE Europe ex UK – demonstrating its strength in both rising and falling markets.
The £157m JP Morgan European Dynamic fund, co-managed by John Baker, Jonathan Ingram and Blake Crawford, is a top quartile performer over 1, 3 and 5 years.
Over three years, it has returned 33.76 per cent, beating both its sector and benchmark which returned 22.1 per cent and 16.84 per cent respectively.
Performance of fund vs sector and benchmark over 3yrs
Source: FE Analytics
Jukes says a stimulus program may also be targeted at certain regions, particularly in northern Europe rather than the debt fuelled south.
“When there have been large volumes of QE in the past these have inflated asset prices, both in equities and in bonds but this round in the eurozone could be more targeted at specific geographical regions,” he said.
In this eventuality he recommends investors instead target stocks or funds exposed to northern European consumers. However he says he is in no hurry to rush into European equities.
“The eurozone has a track record of procrastination and tardiness. As such we are in no rush to start overweighting European stocks, particularly given how far they moved last year despite persistent headwinds to earnings growth.”
