One last shot
Investors should keep the faith in Europe
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