After its March 3rd meeting the European Central Bank (ECB) signaled an important change in the direction of monetary policy, an intention to make a pre-emptive move against the risk of higher inflation. An increase in the main policy interest rate from 1.0 to 1.25% at the ECB’s April meeting is highly probable, unless there is some significant negative development in the meantime. The ECB is, therefore, planning to begin the normalization of interest rates from the current abnormally low level rather earlier than expected. The exceptional support the ECB has been providing to banks will remain unchanged.
This expression of confidence by the ECB in the robustness of the recovery in the Eurozone has been echoed in the equity markets. The MSCI EMU (Eurozone) equity market index is up 9.58% year-to-date on a total return basis, outperforming the benchmark MSCI EAFE (advanced market ex-North America) index, 5.50%; the MSCI USA index, 6.16%; the MSCI Japan index, 3.83%; and the MSCI EEM (emerging market) index, -1.87%. The euro’s exchange rate with respect to the US dollar closed at 1.395 on March 3rd, up 8.1% from its January low at 1.29.
This is quite a contrast from the situation during most of last year, when many market analysts and commentators had a negative view of the prospects for the Eurozone economies; their common currency, the euro; and their equity markets, as a crisis in the sovereign debt markets of the weaker “periphery” members of the Eurozone threatened to spread to the stronger members. Those responsible for economic and financial policies repeatedly had difficulty reaching agreement on needed actions, and the European Central Bank appeared at times to be behind the curve. Some commentators predicted sovereign defaults and even the collapse of the monetary union and the demise of the euro.
We at Cumberland Advisors never shared such dire expectations. However, we did give weight to the risk of spreading contagion and the effects on equity markets as investor concerns increased. We eventually exited all our Eurozone ETF positions with one exception, that for Germany, the largest and strongest of the Eurozone’s core economies. The German economy was clearly experiencing a healthy recovery on the back of strong export growth, particularly to China and other emerging markets. Indeed, the German economy advanced at a strong 3.5% rate in 2010, double the 1.7% advance for the Eurozone as a whole, and there are signs of renewed strengthening in the current quarter. The German country ETF, iShares MSCI Germany, EWG, generated a total return of 26.31% over the past 12 months, including a 9.69% thus far this year, outperforming the iShares MSCI EAFE ETF, EFA (14.57% and 6.13%, respectively).
The signals from the March 3rd ECB meeting were also directed at the heads of government of the Eurozone and the broader European Union, who will be meeting this month with the objective of reaching agreement on a “comprehensive solution” to the continuing debt crisis in the region. While the member countries with the greatest debt problems have been taking difficult steps to correct their fiscal imbalances, spreads between their interest rates and those of the core countries remain wider than can be sustainable over the long term. The deliberations will focus on changes to the European Financial Stability Facility (EFSF) to improve its “effectiveness” (likely involving an increase in its lending capacity) and further definition of a longer-term, permanent European Stability Mechanism (ESM). The ECB is underlining the importance of the heads of government reaching decisions in this month’s meetings that effectively address the debt issues and at the same time maintain the independence of the European Central Bank. Reaching consensus will involve the difficult task of balancing the needs of the weaker “periphery” economies, facing years of sub-par growth, high unemployment, and crushing interest burdens, with the objective of deterring further excessive borrowing in the future. We will not go into the details of these mechanisms here. Suffice it to say, with positive conclusions from these meetings, the euro should emerge with a stronger basis as a global reserve currency. While the weaker member countries will still be facing difficult challenges and Greece in particular will likely eventually need to restructure its debt, the European Monetary Union will not be at risk.
The implications for Eurozone economies and equity markets are mixed but, on balance, positive. The division between the stronger “core” and the weaker “periphery” economies will likely increase with higher interest rates and a stronger euro. While Germany’s and the Netherland’s growth will likely exceed 3% this year and France’s and Austria’s should be over 2%, Greece’s will remain in recession, likely down by over 2.5%. Portugal and Ireland also face continued recession. In between are the important economies of Italy, +1.8%, and Spain, +1.2%.
While relative economic performance is important for equity markets, many other factors (structural, financial, valuation, market sentiment, geopolitical) enter into equity market performance. This year we have started strengthening the Eurozone positions in our International and Global Multi-Asset Class ETF portfolios, focusing on the core economy markets. In addition to the overweight position in Germany noted above (iShares Germany, EWG, up +9.69%), we have added positions in France (iShares France, EWQ, up 10.39% year-to-date), the Netherlands (iShares Netherlands, EWN, +8.01% year-to-date), and Austria (iShares Austria, +2.2% year-to-date).
As for the weaker Eurozone economies, we are the most positive on Spain. It has undertaken decisive policy reforms to address its problems. Its largest banks are strong, thanks in part to one of the better banking regulatory regimes in Europe, and the problems with its weak regional banks, the cajas, are being addressed. Spain’s debt problems are largely in the private sector, where substantial deleveraging is taking place. Despite this deleveraging, the economy has stabilized and recovery has begun. Once it became evident early this year that financial markets considered Spain’s financial situation to be sustainable, Spain’s equity market strengthened. We have added Spain (iShares Spain, EWP, up 13.77% year-to-date) to our portfolios. While the Italian market also has been recovering strongly (iShares Italy, EWI, +13.86% year-to-date), the market capitalization of this ETF is less than we would wish for our portfolios.