After years in which Europe has been an area of concern for investors, we are finally entering, in our view, a more positive phase. Going forward, we believe that five questions will be top of mind for investors.
1) Is this economic improvement sustainable?
The improved resilience of the euro area economy can be explained primarily by two exogenous factors highlighted by European Central Bank (ECB) President Mario Draghi in a recent speech: the oil price collapse that has boosted consumers’ purchasing power, and the ECB monetary policy that has favored a weaker currency, prompted credit easing conditions and favored a convergence in borrowing costs across different countries in the euro area. As the economy progresses, there are signs of a growth engine at work, making the ECB more confident that this recovery can turn into a self-sustaining one. These forces include:
- The virtuous circle triggered by higher consumption leading to higher employment and stronger income growth.
- The robustness of household balance sheets, which we would expect to give consumers a buffer against subdued wage dynamics (especially in some peripheral countries).
- The broad base of the current recovery in terms of sectors and countries, which we believe could further expand, thanks to the rise in global trade and the progress of the “internal devaluation” process. This implies that peripheral, inefficient countries need to experience a long period of lower-than-average wages and prices to regain competitiveness. Italy and, to a lesser extent (because less is needed), France are doing well.
Household Sector Reduced its Leverage, Internal Devaluation is at Play
Source: Pioneer Investments, Thomson Reuters. Data as of April 6, 2017.
Despite these improvements, for which we are optimistic from a European growth perspective, price dynamics remain uncertain and largely driven by energy prices. Euro area core inflation, which catches the “underlying” inflation pressures, was up in April 1.2% from 0.7%, but there are no signs of a persistent uptrend yet. So the ECB will likely maintain the current monetary policy stimulus as planned to facilitate the transition to a self-sustained recovery.
2) Can politics derail the economy?
As the European institutional framework is still a work in progress and requires strong coordinated efforts from member countries, politics becomes crucial. The Eurosceptical forces may be disruptive in this context, but so far their popularity seems contained. Polls have been more reassuring for France, signalling a wide margin of victory for Emmanuel Macron versus Marine Le Pen in the run-off. Polls are also reassuring for Germany where, although the Social Democratic Party of Germany’s rising star Martin Shultz has lost some steam, the consensus for the right-wing, anti-immigrant Alternative for Germany (AFD) is also losing ground. It is clear, however, that Eurosceptic forces remain present in Italy, where there are up to three anti-Europe political parties.
That said, there are also things that seem to be moving in the right direction. EU officials have managed to strike a deal (in principle) on a second review for Greece. Moreover, there were also discussions supporting investment, a common unemployment insurance and a Eurozone-wide “bad bank” facility (along the lines suggested by the European Banking Association).
3) Is there a debt sustainability problem in Italy?
The key question for Italy is that of debt sustainability, and the will of the Italian government to be compliant with the prescriptions included in the fiscal compact.
The main point is that the decline of rates has bought a lot of adjustment time and has eased the burden of the adjustment itself. With a nominal growth rate of 3.2% (which seems attainable) and a cost of debt at 2.4% (which is lower than current figures but corresponds to the yield currently paid by 10-year bonds), maintaining the current level of primary surplus would allow a convergence to the 60% debt-to-GDP target ratio in 30 years. For a quicker convergence, i.e. 20 years (as implied by the debt rule), the primary surplus should increase to 2.9%, which is nonetheless close to the current estimate of the cyclically-adjusted one. This seems to be a viable option. However, problems would arise if conditions worsen. If either nominal growth struggles or the cost of debt servicing rises considerably, the effort required will be much higher.
In conclusion, we believe Italy should be able to grow at a real rate of 1.1% + 2.1% deflator for 20 years, (in line with our forecasts for the next two years) and/or it should show willingness to maintain the adjustment on an ongoing basis in order to avoid a rising interest bill. A nicely scheduled privatization plan could help in confirming the Italian government’s intentions.
4) Is the ECB close to a turning point?
The economic and “financial stress” situation has significantly improved in recent quarters, making exceptional monetary measures less needed than before. But overall, easy financial conditions are still warranted since a significant part of the overall improvement must be accredited to the ECB’s actions. The forward guidance, which stresses that interest rates will be maintained at current or lower rates until well after asset purchases have been terminated, has been recently reaffirmed by the vast majority of ECB speakers. We expect the reference to potential lower rates in the guidance will probably be dropped at upcoming meetings (possibly in June). With monetary policy being defined for 2017 as a whole, market observers are trying to divine what will happen thereafter. Our best take at the present time is that quantitative easing will be run down to zero during 2018 and that the negative deposit rate will then be slowly raised towards zero in 2019. This outcome is, however, conditional on positive results in the upcoming elections for parties in the major European countries, who are happy to continue to implement policies that have enabled the present economic recovery. A victory for the anti-establishment parties in France or Germany this year or in Italy next year would render this situation far more complex.
5) Is it time to be invested in European equities?
On the back of the sustained improvements of the euro area economy, a stronger global economic outlook, and downside risks seeming to be diminishing, we are now more positive on European equities.
We believe that the macro momentum remains supportive for European equities, which could benefit from a re-rating coming from the recovery in profitability expected to support multiples in 2017. After years of underperformance versus the US equity market, European equities may be ready for catch-up.
Earnings per Share on the Rise for Europe