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US vs Europe – What’s what

Ben Chairman

The US economy is expected to grow at a rate of two per cent in 2012 which is below its long-term average. There are three main problems in the US. The $15 trillion debt burden the country has built over the years, the high unemployment rate of close to eight per cent, and the petrol pump prices at unsustainable levels of $4 a gallon which is 2.5 times more than it cost in 2008.

The Fed surprised the markets towards the end of September when it announced a third round of quantitative easing. This was unexpected as elections will take place in November and analysts were predicting QE3 to take place in the first quarter of 2012.

This time round, QE3 is different from QE1 and QE2 because the Fed will be buying mortgage-backed securities rather than US Treasuries. The Fed will continue buying up to $40 billion worth of MBS each month until the unemployment rate starts to fall.

Investors are hedging their portfolio against inflation by moving out of US Treasuries and into Treasury Inflation Protection Securities. Year-to-date TIPS have returned 6.5 per cent compared to just 1.3 per cent for nominal treasuries.

The $15 trillion debt burden in the US is something which is troubling investors but is being pushed to the back burner by US officials as they focus more on job creation. The US had a similar problem in the 1930s and it took a decade for the country to reduce the debt level by half. The US can play for time because inflation is not a threat at the moment. There will come a time in the near future when the US will have to shift focus from growth to inflation.

We like US companies because they are cash-rich and have strong balance sheets. However, valuations are not as interesting in the US as they were in 2008. Then, US equities were trading at a discount of 40 per cent to their long term price-earnings-ratio. Today, US equities are trading at a discount of just nine per cent which makes the risk-reward ratio of emerging market and European stocks more attractive.

Closer to home, European Central Bank president Mario Draghi also came up with a plan to inject money into the eurozone and buy sovereign paper with the hope of keeping yields on Spanish and Italian bonds down. Draghi told the market that the ECB will buy unlimited amounts of Italian and Spanish paper. One would consider this to be a positive statement for the market, but there is more to it than that.

The first point to note is that the ECB will only be buying two- and three-year paper, not long dated paper. Also, for the ECB to start buying these bonds, Spain and Italy must apply with the European Stability Mechanism. The countries will file a report saying they know they were in breach and will rectify their position with the help of the ECB.

The problem is that the ESM has not yet been set up. Additionally, the Troika will visit both Spain and Italy every three months to monitor reform progress for the ECB to buy the bonds. This situation is not as clear cut as it is with QE in the US.

To compound the situation, Germany wants the ESM to be established after the banking union is up and running. The problem is France (and allies) and Germany (and allies) cannot agree on how the banking union should be set up.

The longer it takes the more uncertainty there will be in Europe and the greater the volatility in the markets. If and when the ECB will be buying Italian and Spanish bonds is still up for debate.

JP Morgan doesn’t believe that Greece will exit the eurozone whereas Citigroup is placing a probability of 90 per cent that Greece will exit the eurozone in a year’s time. Greece contributes only two per cent of the eurozone’s GDP.

It is more the contagion effect the Greek exit will have on Spain and Italy that is worrying the markets than a Greek exit itself.

Despite all this negativity in Europe, many stocks trading in Europe are multinational companies exposed to both developed and emerging markets outside the eurozone.

Whereas US stocks are trading at a discount of nine per cent to their long term value, German stocks are trading at a 30 per cent discount and Italian stocks are trading at a 40 per cent discount, making it apparent that alpha could be added to a portfolio by shifting some cash out of US corporates and into companies listed in Europe with multinational exposure. Many investors look at the strength of the euro against the dollar and assume that things are improving in Europe and worsening in the US. This is a misnomer.

The only reason the euro is strengthening is because the expansionary monetary policy carried out in the US is credible, whereas in Europe money injected by the ECB is immediately withdrawn leaving inflation unchanged.

From a technical analysis point of view, the EUR/USD is priced correctly at $1.30.