The Eurozone’s silver lining

Just as it has been hard to work up much excitement over the last couple of years about the eurozone’s grinding emergence from economic despond, so investors should not be too downhearted at the latest lacklustre growth data. Last week, Eurostat revised down its flash estimate for 4Q2016 eurozone GDP growth to 0.4% QoQ, compared with its advance estimate of 0.5% released two weeks ago. The downward revision was due mainly to weaker than expected growth in Germany (0.4% QoQ versus 0.5% expected), continued sluggish performance in Italy (0.2% compared with 0.3% expected) and unexpected quarterly contractions in both Greece and Finland.

At first sight the disappointing downgrades appear to compound investors’ fears about heightened political risk. European equities have performed relatively strongly of late. Over the last three months the MSCI EMU has climbed 9.5% in local currency terms and nearly 8% in US dollars. Nevertheless, investors remain nervous at the prospects of heightened trade frictions between the European Union and Donald Trump’s avowedly more protectionist administration in Washington, the possibility of a strong showing by populist candidates in upcoming European elections, and the danger that Brexit could harm continental exports to the United Kingdom and amplify eurozone financial system instability.

- Last week’s softer-than-expected growth figures might seem to add to this catalogue of concerns. Yet, peering through the political risks and 4Q’s disappointing data, while the eurozone’s growth is undeniably modest, it is looking increasingly broad-based and self-sustaining. Consider the following factors:

- Sentiment remains upbeat. Survey data continue to point to solid economic growth in 2017. Moreover buoyant export orders indicate an upturn in foreign demand, suggesting that the eurozone is participating in a global cyclical upswing. And despite last week’s unexpectedly soft data releases, Citi’s economic surprise index for the eurozone remains close to the top of the range that has prevailed for the last six years.

Eurozone-wide unemployment continues to fall. Admittedly labour market normalization has been a slow process, and patchy—in Italy, where growth remains glacial, the unemployment rate edged higher in the fourth quarter. Even so, across the single currency area, job creation is now running at its fastest rate since the financial crisis, providing powerful support to domestic demand. And with considerable slack in the system in Europe’s southern economies, there is plenty of room for the trend to continue.

- Despite the recent rise in long bond yields, real economy financing conditions remain very easy, for both businesses and households.

- The upturn is spreading. The variation in growth rates both between member countries and among different economic sectors has fallen to its lowest since the introduction of the euro, suggesting that growth is increasingly spilling over from country to country and sector to sector. This spill-over effect should further support aggregate demand, helping the eurozone’s economic expansion to become self-sustaining.

As last week’s data remind us, eurozone recovery is a slow process.

Nevertheless, it is broadening and looks increasingly robust. As a result, the rationale for the European reflation trade remains in place. Investors should maintain their focus on small and mid-cap stocks and sectors best placed to benefit from the broadening of the recovery, like construction.