The latest Greek drama has been a bit too suspenseful for most investors. Are European stock valuations the happy ending?
Classic drama follows a tried-and-true three act structure: set-up, conflict and resolution. Greek playwrights and philosophers invented the structure in 500 BC—a format we still use today in books, plays and Hollywood movies.
For most investors, this latest Greek drama has been a bit too much of a nail-biter. But the good news is that we are now in the third act; therefore, close to a resolution—and that means equity valuations, which had contracted during the conflict phase, could expand again.
The central figure in this story is Prime Minister Alexis Tsipras, elected in January on a platform of opposition to the harsh austerity imposed by Greece’s lenders—the “Troika” comprised of the European Central Bank (ECB), the International Monetary Fund and the European Commission—during the past five years.
A few weeks ago, I wrote that Greece was in a weak negotiating position, given the financial firewalls established in the past few years to protect markets—particularly in Europe—from the aftershocks should Greece become insolvent or leave the Euro Zone. Without the risk of systemic fallout, Tsipras never really had a card to play when the Troika failed to meet his demands. This past weekend, we found out just how veiled his threats were when he was forced to accept terms that were much more onerous than the ones first proposed weeks earlier and rejected at his urging by popular referendum.
Markets are taking these more painful terms in stride and have rallied sharply on the back of the initial agreement. Why? Because investors now see that this situation is closer to the resolution. In effect, we have reached the climax and the tension can now subside.
The other reason is that this outcome, if approved by the various Euro Zone legislatures, is simply just another example of how governments kick the can down the road. Based on what we’ve seen since the financial crisis, markets prefer this approach to austerity. Some might argue with this conclusion given the severity of the deal, but another bailout, no matter how harsh the terms, is still a better outcome for the Greek and European economy relative to an exit from the Euro Zone and the euro. The current rally simply brings Europe back to where it was after the ECB embarked on its quantitative easing (QE) program in January. Europe can now continue its long delayed recovery from the financial crisis.
To appreciate where we are in this recovery, consider the correction in European equity prices that the latest Greek drama triggered.
The chart below clearly illustrates that the ECB’s actions were a game-changer for European equity markets earlier this year. One could argue that these markets got a bit ahead of themselves. When it became clear that Tsipras and his Syriza party would not accede to the Troika quietly, these same markets began to wobble, and we experienced a significant setback in valuations, even though earnings estimates for many European companies were finally starting to rise.
Quantitative Easing Was a Game-Changer for European Equities
The chart also shows that valuations are still below levels in April and are trading at a wide gap relative to US companies. This is significant because European economies are not nearly as far along in their recoveries as the US, which means there is likely more earnings upside potential in this cycle.