Dan pointed out to me a crucial inflection point on the European Bank index, SX7E, chart yesterday:
As of yesterday, the banking index had closed almost right at the $150 level, which was support on several occasions in 2010 and 2011, and potential resistance today. This morning, the index has moved cleanly through $150, trading at its highest level since July 2011.
European banks have doubled since their July 2012 low, led by the banks in the periphery that were left for dead just 18 months ago. The rally in the banks has coincided with a significant decline in peripheral sovereign debt yields. In fact, the Spanish 10 year yield hit its lowest point since 2006 today:
The Italian 10 year yield is also now below 4%. Think about that for a moment – investors are today willing to receive 3.5-4% per annum to hold Spanish or Italian government bonds for the next 10 years. 10 years is a long time. Imagine how much your own life has changed in the past 10 years, and then consider once again whether you’d be willing to lend money to Spain or Italy at 3.5-4% for the next 10.
While I think peripheral bond yields are markers of significant complacency, the ECB has certainly done its job in restoring confidence in the European Union and the Euro as a currency through the various special programs to support sovereign bonds and peripheral banks. The price action of both the equity and the bond markets reflect that. A content and confident Mario Draghi speaks today at 8:30 am EST after the ECB press release at 7:45 am EST. No new action is expected after last month’s rate cut announcement.
However, Draghi’s pro-active monetary stewardship may not be over. Cam Hui noted in his most recent post that Draghi has expressed a desire for more targeted lending schemes:
In particular, one of the trial balloons that had been floated is the implementation of a conditional LTRO program with the intent of raising lending to small and medium enterprises (SMEs):
European Central Bank President Mario Draghi said Monday [December 16, 2013] that any future long-term financing operation will be tailored to ensure the money reaches the real economy but warned it was a complicated scheme that the ECB must consider carefully.
Draghi went on to say that the ECB was considering an LTRO of a different sort, which targets SME lending [emphasis added]:
On the possibility of a conditional long-term refinancing operation (LTRO), Draghi said the ECB’s original LTROs already included elements of the Bank of England’s Funding for Lending scheme and noted there were “operational complications” involved in implementing such programs among 17 countries, rather than one country.
Draghi said that if the ECB were to engage in another LTRO, it would be “making sure that this money reaches the real economy and doesn’t stop in the banks, or [result in] the banks buying bonds only.”
Cam goes on to note the outperformance of small-cap European stocks vs. their large-cap peers over the last year. That outperformance has continued to start 2014, and a more targeted program for SME lending could be another catalyst to further that trend.
I noted in my Macro Wrap post in mid-August that European stock valuations were much more favorable than their U.S. counterparts among large-cap stocks. The same comparison is even more relevant among small-caps. Add it all up, and we’ll be searching for opportunities in Europe on the long side this year, especially if (a big IF) the improved macro backdrop holds.