Who are the winners in central bankers’ race to the bottom?

The European Central Bank, or ECB, ushered in a new era by launching an aggressive bond-buying program in January. The euro zone is one of the global economy’s biggest trouble spots. And this move shifts pressure onto political leaders to restore prosperity in the region. So posits John Stephenson, president and CEO of Stephenson & Company Capital Management in Toronto and a regular contributor to The MoneyLetter. He continues:

Investors cheered the ECB’s commitment to flood the euro zone with more than one trillion euros in new money—more than double the consensus forecast. The bank’s action sparked a rally in both stock and bond markets and sent the value of the euro plunging.

ECB stimulus sinks the euro—as hoped

A day after the ECB’s bond-buying announcement, the euro continued its free fall, blowing past analysts’ expectations for how low the euro can go.

The euro sunk on the news that day, hitting 1.15 to the U.S. dollar, a level not experienced since 2003. Some investors are now saying the euro could fall to the point where it’s at parity with the U.S. dollar, if not a discount. Morgan Stanley recently cut its estimate of where the euro will end 2015 to $1.05 to the U.S. dollar from $1.12 previously.

Quantitative easing—European style

The ECB will buy a total of 60 billion euros a month in assets including government bonds, debt securities issued by European institutions and private-sector bonds. The purchases of government bonds and those issued by European institutions will start in March and are intended to run through to September 2016.

Who carries the risk?

But the question of who may have to foot the bill if things go badly is anything but clear-cut. Much of the risk won’t be shared across the euro zone as a whole, but will instead remain with national central banks.

Under the ECB scheme, the national central banks will also buy bonds issued by European institutions—such as the European Investment Bank—and these will account for 12 per cent of new bond buys. For these bonds, risks will be shared by the ECB and the national central banks. The ECB itself will buy eight per cent of the total size of the program in the form of government bonds.

So, in total, risk will be shared—by the ECB and other European institutions—for just 20 per cent of purchases. For the other 80 per cent, the national central banks will take any losses.

Despite all the tut-tutting from analysts that quantitative easing wouldn’t work in Europe, early indications are that it appears to be working swimmingly. Stocks are higher, government borrowing costs fell and the euro declined.

Success, yes. But who benefits?

A weaker euro is better for the core of Europe rather than the periphery. This is especially true given that the majority of the risks of the new bond-buying program lie with the individual central banks. Germany looks like a beneficiary of the new program and a weaker euro. Contrast that to Spain, which generates about 25 per cent of its sales in Latin America. With that region looking particularly challenged, Spain is unlikely to get as much of a bump up from a weak euro as Germany is.

Central bank stimulus—Canadian style

The much larger than forecast bond-buying program by the ECB follows on the heels of another unexpected move, earlier that week, when the Bank of Canada surprised markets by slashing its own overnight rate by a quarter of a percentage point. The announcement by the Bank of Canada caused stocks to surge while government bond yields fell to record lows and the Canadian dollar endured its sharpest one-day decline in three years.

Between 1986 and 1990, the Canadian dollar rose to 90 cents, but then swooned again, hitting 62 cents to the U.S. dollar in January, 2002—far below its current level. From then until recently, the loonie played footsie with the greenback, usually trading a few cents below par until it began to drift lower. Then, with the near-vertical decline in oil prices, it tumbled to the current 80-cent range.

Where is the bottom for the loonie? Goldman Sachs says 71 cents. Others aren’t so sure.

Land of the Rising Sun engineers a falling yen

In Japan the story is much the same. The Bank of Japan is pumping money into the economy at an unprecedented rate, causing the bank’s balance sheet to swell to the equivalent of more than 50 per cent of the economy.

The yen has fallen by 25 percent against the U.S. dollar over the past two years, inflating exporters’ profits and propelling the Tokyo Stock Price Index, or “Topix,” to its highest level since 2007.

A global trend: Gain strength by weakening your own currency

The upshot of this is that, around the world, central bank stimulus is a depreciation of the domestic currency, accompanied by a surge in risk assets and government bonds. The losers in these experiments are neighboring countries whose exports suddenly look expensive.

The savvy way to play this is to focus on cyclical stocks that will benefit from stronger domestic growth—while central banks are being accommodative—and export-oriented companies.

What I Recommend

Global growth for 2015 is unlikely to accelerate beyond the three per cent or so level that it’s been stuck at since 2012. Recessions in Russia and Brazil, a deceleration in economic growth in China and slowdowns in oil-exporting states are countering modest improvements in Europe and healthy U.S. growth.

Who benefits, and who loses, in this race to the bottom

Global central banks are in a race to the bottom, trying to outdo one another with a lower currency in a beggar-thy-neighbor form of policy wars. The beneficiaries of these policies are export-oriented companies; the losers are companies domiciled in neighboring countries.

Falling crude oil prices are a boon to the consumer, acting as a de facto tax cut and broadly benefiting consumer discretionary stocks.

S&P/TSX versus S&P 500

Canada’s benchmark index, the S&P/TSX composite index tends to be more globally levered than average. Exports represent a third of Canadian gross domestic product, or GDP, and foreign sales accounted for roughly 58 per cent—that’s about 10 per cent more than is the case with the S&P 500.

With the loonie likely to continue sliding further, investors should consider market segments such as aerospace, fertilizers, information technology, forestry, auto parts, and insurers, given the high level of foreign sales these industries have.

CGI Group: Attractive valuation, expanding margins

One company that I like is information technology services provider CGI Group Inc. (TSX─GIB.A; NYSE─GIB). It offers consulting and professional services throughout North America and Europe.

The shares should outperform in the year ahead based on favourable currency movements, further margin expansion, continued growth through acquisition, strengthening cash flow and attractive valuation.

I believe that the next acquisition could be a catalyst for the shares.

The company has indicated that it is looking to double its revenue in the next five to seven years. I have a “buy” recommendation on this stock and a 12-month target price of $61.

Manulife: Improving capital position plus growth in Asia

Another stock I like is Manulife Financial Corp. (TSX─MFC; NYSE─MFC). Manulife has been steadily improving its capital position, has had good results from its franchise in Asia and, in its financial guidance, has been pointing toward improved core investment gains.

The company now believes that $400 million annually in core investment gains is likely as compared to its prior guidance of $200 million.

Additionally, investors in Manulife should experience less volatile earnings than in recent years, as earnings sensitivity to movements in equity markets and interest rates have declined significantly. I have a “buy” recommendation on the stock and a 12-month price target of $32.

MetLife: Rising profit, attractive business mix

Another way to play the insurance theme is through MetLife, Inc. (NYSE─MET). MetLife has a much diversified business line, a strong position in the U.S. variable annuity business, and the largest exposure to rapidly growing life insurance markets such as Latin America and Eastern Europe. Management is held in high regard and the company has a very attractive business mix.

I continue to expect that MetLife will produce strong earnings and improving return on equity (or ROE), a key metric, over the next few years. I also anticipate that more significant capital management will be possible as regulatory uncertainty diminishes.

The stock is attractively valued at 8.5 times 2015 estimated earnings per share, or EPS, and 1.0 times 2014 book value per share.

Canadian investors should benefit, as well, from a favourable currency translation in addition to solid returns in U.S. dollar terms.

I have a buy recommendation on the stock and a 12-month price target of $60.

Oil, the loonie and Canadian investors

The U.S. dollar seems to be destined to continue its appreciation over time. Oil is likely to remain weak as global demand is expected to remain soft.

CIBC estimates that a third of oil’s recent price decline can be explained by factors that have impacted resource markets generally, namely a sub-par global economy.

But the remaining two-thirds appear to be the result of factors specific to oil, notably increasing supply. And supply, at least in North America, is not yet starting to taper off, with U.S. production expected to grow by at least 100,000 barrels a day in February, according to the U.S. Department of Energy.

Investors should concentrate their investments in stocks where Canadian dollar and crude oil weakness are not part of the equation.

While Canadian equity analysts have been slashing their forecasts for energy and base metals producers, forward estimates for other sectors that benefit from weak oil prices and a slumping Canadian dollar have been on the rise. 


The MoneyLetter, MPL Communications Inc.
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