Transient and recurrent headwinds
Eurozone economic growth slowed sharply from a quarterly pace of 0.7% in Q1 2018 to 0.2% in the three months ending in September. A significant part of the deceleration was probably due to transient factors, in particular a drop in car production after a change in environmental regulation. The German Federal Ministry for Economic Affairs and Energy estimates the switch to the new regulations depressed German GDP by up to 0.4% quarter-on-quarter in Q3. A reversal of that special effect should help eurozone GDP to rebound in late 2018 and into 2019.
Italy has become a greater risk for eurozone prospects over recent months. The new coalition government between the left-leaning Five Star Movement and right-of-center League political parties submitted a draft 2019 budget that was badly received by bond markets. A proposed budget deficit of 2.4% of GDP was three times that targeted by the previous government. In response to Italy’s perceived laxity, the European Commission initiated an “excessive deficit procedure”, a mechanism designed to rein in profligate euro-area member countries.
As we show in the chart above, the spread between Italian and German 10-year government bonds jumped sharply after the coalition was formed and continued to rise above 3% as the standoff between Italy and the European institutions escalated. We believe Italy will eventually cave in to demands for a lower deficit, but probably only after a period of even higher Italian bond yields and market volatility. This case for “Italy will get worse before it gets better” could be a recurring headwind over the next few months. In our view, a more benign resolution will be found as 2019 progresses.
- Cycle: Slightly positive. We expect 8% growth in earnings-per-share for the eurozone equity markets in 2019, which would be a positive outcome for investors relative to what they have experienced over the past two decades. To achieve that profit increase, eurozone GDP growth needs to stay at or slightly above the long-run potential of around 1.5%, which we think is very achievable. The main risks to the benign cycle view are the budget conflict between Italy and the EU, a disorderly Brexit, and an escalation of the global trade war. Our base case is for these three risks to fade during the course of 2019.
- Valuation: Neutral. Eurozone equity valuations are neutral relative to their own history as of December 2018, but quite depressed compared to the U.S. market. Income potential from European stocks look tempting for U.S. investors, with the currency-hedged dividend yield on the MSCI EMU (European Monetary Union) Index approaching 6% as of November 21, 2018.
- Sentiment: Slightly positive. Slightly positive euro-area equities have moved into negative terrain in late 2018. While this is a warning signal, our contrarian indicators suggest the decline could be overdone. Several price-based technical indicators are sending buy signals, such as the Relative Strength Index and the Bollinger Band. In addition, the Citigroup Economic Surprise index for the euro area dipped below -50 on October 30, which is the threshold to trigger an oversold signal. Data surprises are now so bad that a rebound is becoming likely, probably through a combination of improving growth indicators and lower economist expectations.
- Conclusion: Investors may be forgiven for growing wary of the many head fakes that the European equity markets have dealt them. According to the Bank of America Merrill Lynch Fund Manager survey published on November 13, a majority of participants seem to have thrown in the towel and are now below their average historical allocation to eurozone stocks. From a contrarian perspective, that bodes better for the asset class. We remain constructive on eurozone equities, especially relative to the U.S. market.