European QE is finally here – better late than never. Importantly, Mario Draghi has left the door open to “do whatever it takes” as far as quantum goes. Euro currency debasement will likely be a feature for several years to restore competitiveness. At this point in the Eurozone, disinflation has taken a strong hold and outright deflation is on the cards. For this reason, EU QE is likely to be less effective than it was in the US and UK as consumer sentiment and unemployment had not deteriorated quite as far in the Anglosphere. The key areas to watch are: the exchange rate (already falling, and has broken the Swiss currency peg), bond rates (already falling, ex-Greece), increasing asset prices, and eventually increasing lending to SME’s. If everything works as hoped, falling unemployment and growing GDP will increase taxation revenue and lead to moderate inflation. Well, that is the plan, but time will be the judge. To some (unknown) extent, it has worked for the UK and US, so what is the worst that could happen?
Answer: the world losing faith in the euro currency and hyperinflation. But let’s not get too negative just yet. Japan is likely to crack on that front well before Europe. Germany’s hard won experience and influence will keep things much tighter and disciplined than the Japanese experiment.
If all works to plan, where are returns likely to be generated? Local cyclicals (construction, autos), exporters (LVMH, Volkswagen, Siemens, L’Oreal, SAP, BMW) and tourism are candidates, and leveraged cyclicals likely the biggest winners. Banks spring to mind. For some time, European banks have been under extreme duress as economic conditions deteriorated and remain depressed. But the environment is likely to improve, albeit slowly, from here.

Figure 1. QE to boost Europe
Source. Credit Suisse Research

Figure 2. Europe GDP recovering
Source. Credit Suisse Research

Figure 3. European Retail
Source. Credit Suisse Research

Reporting Season in Australia

Reporting season overall has been quite reasonable, with a key feature being more cost control than revenue growth – although the poor results are usually left to the last few days. Local equities are not as attractive as they were the prior month, thanks to the RBA rate cut, a splash of M&A fever (thanks to Japan Post and Toll Holdings) and expectations baked in for more rate cuts to come. When fear is absent, interest rates are like gravity for asset prices. From a fundamental perspective, forecast forward returns from equities locally and globally are subdued, and negative in most developed markets. While future equity returns are likely to be low, returns from other asset classes are likely to be even lower. Until interest rates rise (creating real investment alternatives) equities are likely to remain well bid, however more sensitive to shocks and sharp corrections.

Figure 4. Global Equity Price & Value
Sources. MSCI Price Data
Recently, Jeremy Grantham and Robert Shiller have commented on high price levels for global equity; both commentators are highly regarded and have strong records in observing markets and estimating their forward return characteristics. Shiller’s cyclically adjusted price-to-earnings ratio (CAPE) and our equity multiple valuation model indicate the US market is more expensive today than it was just before the GFC, but not as extreme as the prevailing prices toward the end of the dot-com boom in 2000 (which was on par with 1929).
The local market is climbing the proverbial “wall of worry” and while it does have some people worried, equity prices are not at extreme levels. One should be concerned if prices are greater than 15% above value, or if you are anticipating a local recession – as in such circumstances earnings will be challenged and bank bad debts will surge. A “muddle-through” outcome from this GDP slowdown will sustain asset prices, although monetary policy may need to do more work in the absence of political leadership and fiscal stimulation.
A wonderful read on the performance of equity over the long term is the Credit Suisse Yearbook (view document). There certainly is risk being invested in equity today, however over the longer term there is more risk not being invested.

Australian equity long term return profile

Figure 5. Australian equities, cumulative real returns (1900 – 2014)
Source. Credit Suisse Research

Global Equity long term return profile

Figure 6. Global equities, cumulative real returns (1900 – 2014)
Source. Credit Suisse Research
We have endured the longest bear market in Australia’s history and the recent monetary policy driven surge has taken us closer to 100% recovery of previous falls in the sharemarket index. If the economy avoids a more severe downturn (perhaps 50% chance) and monetary policy is loosened further causing additional AUD depreciation (a >50% chance), it is probable over the next 12-18 months that our market will head toward 100% recovery. History is on the side of the bulls, however the bears have much to keep them interested.