Inflation Expectations, Eurozone Stocks

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Inflation Expectations, Eurozone Stocks

Two “Data” items today:

Issue #1: Inflation expectations ahead of Thursday’s Consumer Price Index report for May 2021 and the FOMC meeting next week.

The bond market’s expectations of future US inflation have gone nowhere in over 2 months, as this 2019 – present chart of 5- and 10-year TIPS imputed inflation shows. At the start of April 5-year TIPS priced in 2.55 points of future CPI inflation; now, they price in 2.51 points. The same applies to 10-year TIPS: 2.35 points on April 1st, 2.39 points now. Worth noting: this time period includes May 19th’s +4.2 percent CPI print – that small hump you see on the rightmost side of the chart was in the lead up to that release.

Takeaway: TIPS are strongly signaling that they see upcoming +4 percent CPI reports as representing only transitory inflation. If headline CPI inflation runs +4 percent for the next year, for example, current 10-year TIPS pricing imputes that it will only run 2 percent for the next 9 years. Which, of course, is exactly the Fed’s long guidance.

The other point we want to raise with you on this topic is “what does the Federal Reserve see when it looks at market-based estimates of future inflation expectations?”

This chart of TIPS inflation expectations from 2003 – present is one way to answer that question. Here is what we see in the data:

  • Before the Financial Crisis (2003 – 2008), bond markets consistently priced future inflation of 2-3 percent. That was in line with then-current readings and, just as importantly, the Fed’s own 2 percent goal.
  • After the Financial Crisis (2010 – 2014), expectations oscillated around 2 percent. That was not a disaster for the Fed, but neither was it a vote of confidence in their ability to keep inflation at their target given we were past the Great Recession.
  • The 2015 – 2020 period, when inflation expectations were consistently below 2 percent, is what troubles Fed Chair Powell right now. He mentions it at every post-FOMC meeting press conference. Sub 2 percent inflation in boom times all but assures deflation in a recession and possibly thereafter, as the Japanese experience post-1990 shows all too well.

Takeaway: we keep coming back to the old political adage “never let a crisis go to waste” when we consider why the Federal Reserve is keeping policy rates and bond purchases so accommodative. They see the recovery from the Pandemic Recession as a chance to reset inflation expectations back to levels last consistently seen when Alan Greenspan ran the institution. This is something that bothers many people, and we get that. We do, however, remain skeptical that an aging, slow growth population such as exists in the US can really see sustained inflation rates. Just look at Europe or Japan for analogs …

Issue #2: How to play the European economic recovery. We’ve been highlighting the region’s recent snapback in Sunday’s Disruption section over the last few weeks, which is far outpacing that of the US. This makes sense. Much of the Continent and the UK had much stricter and longer lockdowns, and fiscal stimulus during the pandemic was a fraction of what we saw in America. Europe’s recovery in 2021/2022 should look more like a typical V-bottom than what we’re likely to see in the US.

Also worth noting: European equities are notionally cheaper than US stocks. The S&P 500 trades for 21x forward earnings, while Europe goes for 17x. And MSCI Europe is only up 11 percent from its Q1 2018 highs; the S&P is 47 percent higher since then.

Those are the pros to European stocks (reopening, cheap), now here’s the other side of the coin: they are an unhedged bet on further global economic recovery.

To explain what we mean, here are some Euro-recovery plays to consider:

#1: MSCI Europe (symbol IEUR). This index spans UK stocks (24 percent weight), France (16 pct), Switzerland (14 pct), Germany (14 pct), the Nordic region (12 pct), Italy (4 pct), Spain (4 pct), and the rest of the region (12 pct). So, it’s a pretty diversified basket …

But … the sector weightings are much more cyclical than the S&P 500:

  • Tech is just 8 percent of MSCI Europe, versus 26 pct for the S&P
  • Industrials and Financials are 32 percent of MSCI Europe and 21 pct of the S&P
  • Materials and Energy are 12 percent of MSCI Europe and 6 pct of the S&P
  • Consumer Discretionary is 12 percent of MSCI Europe, but just 8 pct of the S&P when you exclude Amazon (4 pct)

#2: Within even individual MSCI country indices, cyclical company allocations can vary widely. Here are the collective weightings of Financials, Industrials, Consumer Discretionary, Energy and Materials for the larger markets (note: S&P weighting is 32 percent ex-Amazon):

  • United Kingdom (symbol EWU): 58 percent
  • Germany (EWG): 60 pct
  • Italy (EWI): 64 pct
  • France (EWQ): 66 pct
  • Switzerland (EWL): 32 pct
  • Spain (EWP): 54 pct

#3: There is obviously no “Apple of Europe”, or a Microsoft, Amazon, Facebook or Google either. Those companies are 21 percent of the S&P 500. This, by the way, is why MSCI Europe Index trades cheap to US equities. It’s not mispricing; it is an almost complete absence of companies that leverage disruptive innovation at a global scale. The top 3 Tech weightings in MSCI Europe (ASML at 2.2 pct, SAP at 1.1 pct, Infineon at 0.4 pct) are all fine companies but none have the addressable market of a US Big Tech company.

Summing up: being long European equities as a cyclical trade is fine, and we continue to favor UK equities (EWU) but also see upside for the MSCI Europe Index (IEUR). Investor appetite for economically sensitive sectors should continue as companies show earnings leverage in a recovery. There is, however, little of the technology exposure in this region that has made US stocks much better performers over the last decade. So, it’s a trade, not an investment.