Europe’s breakout problem
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.