One last shot

In­vestors should keep the faith in Europe

Financial Times Middle East - - Front Page - Stephanie Flan­ders Stephanie Flan­ders is chief mar­ket strate­gist for Europe at JPMor­gan As­set Man­age­ment

Many in­vestors gave up on con­ti­nen­tal Europe in 2016. There was a net out­flow from Euro­pean eq­uity mar­kets for the first time in five years. This stance made sense at the turn of the year, when op­ti­mism was rid­ing high in the US and the risk of fur­ther pop­ulist up­set sin Europe was all that any­body could talk about.

Now spring has ar­rived and the world looks a bit dif­fer­ent. As many have noted, the global eco­nomic en­vi­ron­ment has im­proved markedly, in ways that would usu­ally ben­e­fit Euro­pean com­pa­nies more than most. Ar­guably, the bal­ance of po­lit­i­cal risks has also shifted in a pos­i­tive di­rec­tion.

With the French and Ger­man elec­tions get­ting closer and con­tin­ued un­cer­tainty in Italy, there is still scope for vot­ers to cause in­vestors trou­ble. But for the first time in many years, there is also a non-neg­li­gi­ble chance that pol­i­tics in the eu­ro­zone will not just mud­dle along — but end the year in a stronger po­si­tion to sup­port growth and re­form.

At the very least, in­vestors should stop as­sum­ing that po­lit­i­cal change can only make things worse.

The most im­por­tant eco­nomic change is the prospect of re­fla­tion, not just in the US but glob­ally. Global man­u­fac­tur­ing PMIs hit a mul­ti­year high in Jan­uary and eu­ro­zone PM Is are also at their high­est lev­els since 2011.

Just as vi­tal to global in­fla­tion prospects is the eas­ing of de­fla­tion in China. Chi­nese pro­ducer price in­fla­tion has been run­ning at an an­nual rate of 6.7 per­cent since De­cem­ber. That is the fastest quar­terly pace in more than five years.

That lack of de­fla­tion­ary pres­sure from China, by it­self, will not push the eu­ro­zone’s in­fla­tion rate back to the 2 per cent tar­get. But it should make a mean­ing­ful dif­fer­ence to nom­i­nal growth in the eu­ro­zone, which should feed through into higher cor­po­rate earn­ings.

With in­fla­tion still low, in­vestors know that mon­e­tary pol­icy will re­main ex­tremely loose in the euro zone for some time to come, despite ris­ing rates in the US. But they have also grasped that the EC B does not see any fur­ther ben­e­fit in flat­ten­ing the yield curve — or push­ing 10-year Bund yields lower and lower.

The re­sult­ing rise in long-term lend­ing rates means that the per­for­mance of Euro­pean fi­nan­cials should im­prove and an­other ma­jor drag on the Euro­pean stock mar­ket will lift.

An­other pos­i­tive for the Euro­pean mar­ket is that prof­its of Euro­pean com­pa­nies have tra­di­tion­ally been more sen­si­tive to changes in global growth than other mar­kets

There are two big rea­sons why in­vestors have con­tin­ued to give the eu­ro­zone a wide berth — despite these im­prov­ing fun­da­men­tals: his­tory and pol­i­tics. The his­tory is that Euro­pean equities have been un­der­per­form­ing the S&P 500, with few in­ter­rup­tions, since 1987. In dol­lar terms, the re­turn on the US mar­ket has been 2.5 per cent a year higher, on av­er­age since the start of the cen­tury.

There are many rea­sons for this short­fall: par­tic­u­larly low nom­i­nal growth rel­a­tive to GDP in the euro zone and an over re­liance on un­der­per­form­ing sec­tors such as fi­nan­cials and com­modi­ties rather than stronger per­form­ers such as tech­nol­ogy. But po­lit­i­cal risk has also been a con­stant prob­lem, and we face plenty more of it in 2017.

We can­not be sure that Em­manuel Macron will be elected pres­i­dent of France. There are also im­por­tant ques­tion marks about his ca­pac­ity to com­mand a work­able ma­jor­ity in the French par­lia­ment. Sim­i­larly, in Ger­many, it would be a brave in­vestor who as­sumed that Martin Schulz would pre­vail over Angela Merkel. But the prob­a­bil­ity that Mr Macron and Mr Schulz will come out on top is a lot higher than it was at the start of 2017, and surely higher than that of Marine Le Pen up­turn­ing the sta­tus quo in France.

If we did see vic­to­ries for Macron and Schulz, in a lit­tle more than six months, we might — just might — be look­ing at not only a re­vived centre-left, pro-Euro­pean ma­jor­ity in the heart of Europe but also, cru­cially, a more con­struc­tive re­la­tion­ship be­tween France and Ger­many. That kind of pos­i­tive re­align­ment in Europe is prob­a­bly not the most likely out­come from here, but it is at least as likely as the pop­ulist path to hell.

This is not an ar­gu­ment for blind op­ti­mism. It is an ar­gu­ment for in­clud­ing down­side and up­side po­lit­i­cal risk in the equa­tion for Euro­pean mar­kets in 2017, when the eco­nomic fun­da­men­tals are strength­en­ing. The long-term chal­lenges for Europe are still im­mense. But in­vestors with a 12- month time hori­zon who gave up Euro­pean equities in 2016 may end up wish­ing they had given it one last shot.

In­vestors should stop as­sum­ing po­lit­i­cal change can only make things worse

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