The gap between sentiment and fundamentals is too wide for comfort, writes Nicholas Spiro, the London-based managing director of Lauressa Investments and owner of Spiro Sovereign Strategy.
The gap between sentiment and fundamentals is too wide for comfort, writes Nicholas Spiro, the London-based managing director of Lauressa Investments and owner of Spiro Sovereign Strategy.
The troubling disconnect between liquidity-fuelled capital markets and struggling economies has been a persistent theme since the global financial crisis erupted in 2008. Quite often it has felt like markets and economies exist in parallel worlds. The ultra-loose monetary policies of the world’s main central banks continue to inflate the prices of assets, desensitising investors to risks which would otherwise be of far greater concern to them. Central bank largesse may have helped avert a depression in 2009, but in the last two years or so it has distorted asset prices excessively and led to dangerous levels of investor complacency eerily reminiscent of the years leading up to the financial crisis.
The distorter-in-chief, the US Federal Reserve, has finally ended its programme of quantitative easing (QE) and is now preparing to raise interest rates sometime next year provided the US economic recovery remains on track. Yet Europe’s monetary policy is moving in the opposite direction. Amid mounting fears of a ‘Japanisation’ of the eurozone - seven of the bloc’s economies, including Spain and Italy, are now suffering from deflation, a huge concern for Italy in particular given its heavy public debt burden amounting to a staggering 135% of GDP - the European Central Bank (ECB) is under intense pressure to undertake a Fed-style programme of full-blown QE involving the purchase of government bonds.
The mere hope that this will happen is helping push down government bond yields further regardless of country-specific risk. Italy’s 10-year borrowing costs stood at 2.5% in early November, a near record low, while Hungary’s stood at 4%, a historical low. Debt markets are rallying despite mounting concerns about economic and political vulnerabilities in both the core and periphery of the eurozone and, crucially, doubts about the ability and willingness of the ECB to counter the threat of deflation.
EQUITY MARKETS HAVE CORRECTED SHARPLY
This makes the gap between investor sentiment and underlying fundamentals in Europe all the more dangerous - and prone to an abrupt and potentially destabilising change in market conditions.
Equity markets have already undergone a sharp correction. Eurozone stocks have fallen 9% this year (compared with an 11% gain in the benchmark S&P 500 US equity index and a 1.3% rise in emerging market shares), with German and French shares among the worst performers. The significant deterioration in Germany’s supposedly resilient economy - which suffered an outright contraction in output in the second quarter - is particularly bad news for Central European markets which are heavily integrated into the country’s manufacturing supply chain.
The eurozone recovery story, which was one of the big themes in the first-half of this year, is much less convincing now. Rather than signs of a gradual improvement in economic conditions, the last five years have felt like a slow-burn crisis featuring sharp shifts in sentiment stemming from both exaggerated fears (the break-up of the eurozone being the most conspicuous one) and hopes (the talk of a meaningful recovery in Spain amid 25% unemployment and subdued domestic demand being a prominent example).
In Europe’s commercial property investment market, the increased attractiveness of the asset class relative to volatile equities and low-yielding government bonds is helping underpin the weight of capital chasing assets and compressing yields. Yet beneath the surface of favourable sentiment, investors and developers harbour growing concerns. The disconnect between the investment and occupational markets is becoming more pronounced.
Poland is one of the countries in which sentiment in the investment market - and indeed towards the economy in general - has become too detached from the underlying fundamentals of the occupier market. The Warsaw office market has been a tale of two halves for some time now. The first half is a fairly buoyant investment market – this year’s transaction volumes are likely to exceed last year’s €1.2bn - by dint of its relative depth and liquidity, while the second is a double-digit vacancy rate that continues to rise, with completions far exceeding absorption and the likelihood of oversupply in the coming quarters.
Yet at least the foundations of Poland’s economy and creditworthiness are among the most secure in the increasingly vulnerable Emerging Europe region. Poland remains one of the cleanest shirts in a dirty basket. The challenge for property investors in Poland, and across Europe more broadly, is to manage their expectations more carefully. The gap between sentiment and fundamentals is too wide for comfort.
Nicholas Spiro is the London-based managing director of Lauressa Investments