Europe: a contrarian investor's dream
By
MoneyWeek editor-in-chief
Merryn Somerset Webb Nov 21, 2011
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According to many, the West – and Europe in particular – is well on its way to becoming the new Japan. We've got property crashes; we've got regular stock market crashes; we've got near-zero interest rates; we've got zombie banks – institutions kept alive by a rotten mixture of state subsidy and consensual denial; we've got poor demographics; we've got out-of-control sovereign debt; and we've got useless politicians. But, while there is no denying these unpleasant similarities, there are major differences too.
Most obvious of these is the fact that nowhere in the West has deflation.
In Japan, as Mizuho's Jonathan Allum points out, deflation meant that money was never really cheap. Real interest rates were always positive, so the cost of servicing debt always stayed high and the real-value debt didn't decline over time. Nasty.
In the West, things are different. Thanks in part to the fanatical zeal with which Ben Bernanke and Sir Mervyn King are dealing with the threat of deflation, we have mild (so far) but persistent inflation instead.
With interest rates at 0.5% in the UK and 1.25% in the eurozone, that means that real interest rates are negative for many borrowers. Money is very cheap indeed (if you borrow at 3% and inflation is 5% you are doing pretty well).
This doesn't mean things are OK; they aren't. But it suggests more in the way of stagflation than deflation. That, as Allum says, "isn't much fun", but it isn't Japan, either.
In Europe, there is another very major factor that makes it impossible for the eurozone to ever be the new Japan. The market hasn't yet decided that Japan is bust. It has, however, decided that, in one way or another, most of Europe is bust.
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This might not seem fair, given that, on the face of it, Japan's debt is much higher than that of all European countries. But markets don't really do fair. As Rogoff and Reinhart point out in their work on previous debt crises – This Time is Different: A Panoramic View of Eight Centuries of Financial Crisis – there is no set point at which high levels of public debt tip over from being a pain to being a crisis. It happens when the market makes it happen.
So Japan, while not averse to a little quantitative easing, has not yet had to print money in vast volumes in order to monetise its debt.
Europe is going to have to. If the European Central Bank (ECB) and Germany want to keep the euro together under the current circumstances (no growth, high debt and an angry market), they are – as Société Générale's Albert Edwards puts it – going to have choose between their "two most cherished ideals: the euro or hard money principles".
Either they print oodles of money and use it to buy up every European sovereign bond in sight, or they wave goodbye to their dreams.
Might this eventually lead to very high inflation and even hyperinflation?
It could do. The history of huge fiscal deficits being dealt with by huge money printing programmes is not a happy one – which of course is why the German authorities aren't that into the idea, and why they will want to demand a promise of fiscal union before they agree to it.
However, in the meantime, it should probably make you feel reasonably bullish for the prospects for the European market a year or a two out – and much more bullish than you might have felt about Japan in, say, 1993.
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I've listened to two excellent European fund managers speak this week.
They pointed to shares trading on low price/earnings (p/e) ratios across the region – based both on one-year earnings and earnings averaged over ten years. They noted the relatively high yields on offer. They explained why a merger and acquisitions boom is in the offing and how, in times of trouble, quality companies take market share from the weak.
And they pointed out that, given its unpopularity with investors, Europe is something of a contrarian's dream. Of the global investors surveyed by Bloomberg a few weeks ago, 53% said they expected Europe to offer some of the world's worst investment opportunities over the next year – and money has been flowing out of the zone all year.
If you think one of the keys to successful investing is going where others won't, say the managers, it is hard to see how you might find a better bet.
That's all true. There is a reason to get into European equities simply because no one else will, as this does make them cheap (although nothing is ever so cheap that it can't get cheaper).
However, the real reason to think about buying a little is less complicated: markets are moved by money and the ECB has little choice but to make more of it. It is unlikely to do so in the near future: the German position is nothing if not intransigent. But when this crisis gets bad enough that the ECB starts doing so, European markets will soar – and they should do so regardless of whether they represent value or not.
• This article was first published in the Financial Times
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