Europe’s break­out prob­lem

Financial Mirror (Cyprus) - - FRONT PAGE -

The euro­zone’s cycli­cal re­cov­ery re­mains less than stel­lar, yet at least it lives. The sin­gle cur­rency area’s com­pos­ite flash PMI for Oc­to­ber recorded its strong­est read­ing since Jan­uary 2015, ris­ing to 53.7 against an ex­pected 52.8. The read­ing was flat­tered by weak­ness in the last two months, but con­firms that Europe has, for now at least, weath­ered the Brexit vote shock. What is es­pe­cially en­cour­ag­ing is the breadth of the im­prove­ment, which has spread well be­yond the Teu­tonic heart­lands. And yet as Europe’s resur­gent eq­uity market read­ies to test a crit­i­cal thresh­old, we still have a fore­bod­ing sense of this be­ing a de­cep­tive calm be­fore the storm.

First the good news. The euro­zone’s man­u­fac­tur­ing PMI in Oc­to­ber hit a 30-month high of 53.3, im­ply­ing that Au­gust’s 1.8% rise in in­dus­trial pro­duc­tion was more than a blip. Af­ter a bout of sum­mer angst, Ger­man fac­to­ries are again hum­ming, but so are French ones. A weak euro is help­ing man­u­fac­tur­ers, which re­ported strong de­mand from the US and Asia.

Such strength should help mit­i­gate fu­ture weak­ness in UK de­mand. Euro­pean ser­vice providers are also on the up, led by Ger­many, where a Septem­ber wob­ble was shown to be an out­lier. On the back of im­proved con­sumer con­fi­dence read­ings, the euro­zone ser­vices PMI rose to a nine month high of 53.5.

Europe should also ben­e­fit from an ap­par­ent res­o­lu­tion to Spain’s po­lit­i­cal dead­lock—de­spite two gen­eral elec­tions, the coun­try has been with­out a gov­ern­ment for ten months. The so­cial­ist PSOE party’s de­ci­sion to ab­stain from a con­fi­dence mo­tion to be held be­fore Mon­day should al­low Mar­i­ano Ra­joy’s Pop­u­lar Party to form a mi­nor­ity gov­ern­ment. In­vestors have been roiled by cen­trifu­gal forces in Euro­pean pol­i­tics which sug­gested a dis­in­te­gra­tion of sup­port for cen­trist so­lu­tions. This move would seem to be a vic­tory for old style deal­mak­ing of the sort Europe spe­cialises in.

The com­bi­na­tion of an im­proved eco­nomic out­look and more re­al­is­tic pol­i­tics has helped push the Eurostoxx back to the 335 thresh­old, which in April and Septem­ber proved to be a strong re­sis­tance level. Yet while the over­all news flow has im­proved in re­cent weeks—and it is pos­si­ble the 3Q16 earn­ings re­ports may of­fer a cat­a­lyst—we are skep­ti­cal that the eq­uity bench­mark can achieve a de­ci­sive break­out for two rea­sons:

While it is nice to see Spain fi­nally choose a gov­ern­ment, this is small beer com­pared to the threat posed by Italy’s elec­torate should Mat­teo Renzi’s re­form pro­gramme be re­jected at a De­cem­ber 4 ref­er­en­dum, po­ten­tially set­ting Italy on a course to exit the euro. Only 54% of Ital­ians have a pos­i­tive view of the euro, ac­cord­ing to Euro­barom­e­ter, which is well be­low the euro­zone av­er­age of 70% and even lower than Greece at 62%. We can­not claim to be able to pre­dict the pas­sage of Ital­ian pol­i­tics af­ter a (quite likely) “no” vote, but we are fairly sure that it will lead to a pick-up in as­set market volatil­ity.

An­other rea­son to think that euro­zone eq­ui­ties will strug­gle to break their shack­les is that re­cent gains have been spurred by a re-rat­ing of banks, on hopes for a steeper yield curve. Such hopes are likely over­done as (i) the Euro­pean Cen­tral Bank will likely ex­tend its bond buy­ing pro­gram be­yond March 2017 and (ii) the ECB is be­ing forced to con­cen­trate its pur­chases at the longer end of the yield curve as many shorter-dated ma­tu­ri­ties yield be­low - 0.4%, and so can­not be bought.

In sum­mary, we are far from con­vinced that the euro­zone is out of the woods. The re­cent sharp fall in ster­ling of­fers a warn­ing that much is at stake in forth­com­ing Brexit ne­go­ti­a­tions and blow­back ef­fects to the rest of the Euro­pean Union are likely. Sep­a­rately, the col­lapse of the Canada-EU trade deal this week­end is a re­minder that Europe’s struc­ture is ex­posed to small but grow­ing pop­ulist vested in­ter­ests that block progress. Taken to­gether, an uptick in volatil­ity should be ex­pected be­fore the year end.

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