The eurozone: Maintain your enthusiasm Gas in the tank

In order to explain why we think there are still gains to be had, it is important to start with our analysis of both the size and value of future earnings. With respect to the size of future earnings, we see a positive impact from a continued economic recovery, rising profit margins, and a weaker euro. With GDP growth expected to continue at 1.5%-2%, driven by pent-up consumer demand, positive credit growth, a cheap euro, and low oil prices, revenue growth should be supported. At the same time, profit margins are expected to keep on trending higher as the input cost of raw materials is falling and wage growth is low. Finally, the weaker euro is supporting the export sector and is boosting foreign earnings in euro terms. Combined, we expect corporate earnings to grow by 4-8% in 2016, which, given the 10% growth¹ already achieved in 2015, is quite healthy.

With respect to the value of future earnings the focus lies on the discount rate used to calculate their present value. We expect the discount rate to remain under downward pressure from loose monetary policy. Indeed, although European Central Bank (ECB) President Mario Draghi boosted monetary policy on Dec. 3, 2015, he did not quite meet elevated market expectations.

In previous reports, we’ve often focused on eurozone tailwinds and our focus on the balance between reflationary and deflationary forces. Nothing has really changed in this respect. What has changed, however, is the fact that expectations have been steadily increasing. Not only does that make it harder to surprise on the upside, it also means more of the recovery has been priced in already.

After meeting our target for 10% corporate earnings growth in 2015 we are looking for a healthy 4% to 8% in 2016. In fact, for government bonds in the periphery we have trimmed our overweight back to neutral after reaching our target spread of 1% versus German bunds (see chart on page 9). In equities, however, we still strongly favour the eurozone because the supports mentioned above are combined with relatively cheap valuations versus U.S. equities.

10-year bond spread relative to Germany

Source: Thomson Reuters Datastream: Benchmark Bonds data as of Dec. 3, 2015

Revisiting our watchpoints

As always, we continue to monitor watchpoints for signs of trouble:

• The 5-year, 5-year forward inflation swap. At approximately 1.7%, this watchpoint is still flashing amber, although only slightly. We would like to see inflation expectations pick up a bit more, and we expect the latest ECB moves to do just that.
• Credit impulse. The credit impulse (the change in credit growth) has gone back from a slight shade of amber to a slight shade of green. Credit growth has picked up again after a lull in the third quarter and the ECB’s Senior Loan Survey continues to improve.

Strategy outlook:

• Valuation: Eurozone equities are neutrally valued in an absolute sense, but they are cheap relative to the U.S. In government bonds we have gone back to neutral in peripheral bonds after having gone back to neutral in core bonds last quarter.
• Business cycle: We maintain our positive outlook for the business cycle although higher expectations have caused us to trim our score a tad. GDP growth in 2016 is expected to be 1.5% to 2%, the same as in 2015. After meeting our target for 10% corporate earnings growth in 2015 we are looking for a healthy 4% to 8% in 2016. Finally, both fiscal and monetary policies remain supportive.
• Sentiment: Price momentum is still neutral, but our contrarian indicators continue to keep the overall score slightly positive.
• Conclusion: We maintain our overweight position to eurozone equities, but we go to neutral in peripheral bonds alongside our existing neutral position in core government bonds.

¹ Based on the MSCI European Monetary Union Index- (in €), 12-month-trailing earnings-per-share as of Nov. 30, 2015.

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The Business Cycle Index (BCI) forecasts the strength of economic expansion or recession in the coming months, along with forecasts for other prominent economic measures. Inputs to the model include non-farm payroll, core inflation (without food and energy), the slope of the yield curve, and the yield spreads between Aaa and Baa corporate bonds and between commercial paper and Treasury bills. A different choice of financial and macroeconomic data would affect the resulting business cycle index and forecasts.

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The S&P 500, or the Standard & Poor’s 500, is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.

The Russell Eurozone Index measures the performance of the equity markets located in the Euro Zone, based on all investable equity securities in the region.

The Bloomberg U.S. Aggregate Bond Index is a broad based index often used to represent investment grade bonds being traded in United States. It is maintained by Bloomberg.

Bloomberg U.S. Corporate Investment Grade Index is an unmanaged index consisting of publicly issued U.S. Corporate and specified foreign debentures and secured notes that are rated investment grade (Baa3/BBB-or higher) by at least two ratings agencies, have at least one year to final maturity and have at least $250 million par amount outstanding.

Bloomberg U.S. Corporate High Yield Index is an unmanaged index that covers the US dollar-denominated, non-investment grade, fixed-rate, taxable corporate bond market.

The MSCI EMU (European Monetary Union) Index is an unmanaged index considered representative of the EMU group of countries.

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2016 Annual Outlook
UNI-10682