The drivers we expect to push eurozone financial markets higher are still in place, although we admit a few have lost some luster. Economic growth, despite a modest slowdown, remains robust and corporate earnings are advancing at a healthy pace. In both cases, we have seen growth rates step back from the upper end of our expected range for 2018, to the middle. While that diminished their shine, we are not concerned about it, especially when confidence is strong and profit margins are improving. The return breakdown of the eurozone equity market in the chart below shows how these fundamental drivers of return have dominated overall returns, without the help of higher valuations. We see this as a comforting return profile with plenty of upside potential.
Additionally, financial conditions are loose and credit growth is rising. Of course, we take note of the risk that both may tighten if the European Central Bank (ECB) decides to end its quantitative easing program or if political theater in Italy causes a full-blown crisis of confidence. But, not only are those risks probably mutually exclusive, for now both seem manageable. And with the euro turning from a headwind into a tailwind, currency is providing noticeable support.
Opposite the drivers pushing eurozone financial markets higher are the forces pulling them lower. Currently we believe the risks associated with the latter have clearly increased. First and foremost, that is true for political risk. We have worried about Italy for more than a year now, and in the past few months we have been reminded why. A coalition between the populist Five Star Movement (M5S) and far-right Lega political parties, with a fiscally irresponsible agreement underpinning it, has spooked markets. We now must wait to see how much of their plans they actually try to implement. We are cautiously optimistic that the constraints imposed by President Mattarella and financial markets will keep them in check. As such, for now we think the risk is manageable.
Other political risks have also increased. The Brexit negotiations between the UK and the European Union (EU) are not going all that well as the UK struggles to come up with solutions to problems posed by, for instance, the Irish border. We still expect an agreement will be reached to implement a two-year status-quo transition period, but we worry about the UK’s internal political fragility in getting there.
Finally, the political risk regarding global trade has reemerged. The tariffs imposed by the U.S. on steel and aluminum have kicked off a cycle of retaliation and recrimination. For now, we are hopeful cooler heads will prevail, but we are closely monitoring developments. Should the situation escalate, it will weigh on the eurozone because it is sensitive to disruptions in global trade.
- Business cycle: GDP growth has cooled from a level close to the upper end of our 1.8-2.4% range to the middle. The same has happened in corporate earnings growth in our 5-10% range for 2018. This slowdown, combined with increased political risk, has caused us to lower our business cycle score. Regarding the ECB, we continue to expect a dovish tilt this year, but we are monitoring its communications carefully as the end of quantitative easing draws near.
- Valuation: Eurozone equity valuations are neutral while core government bonds are long-term expensive. We decided to slightly alter our range for core bond yields from 0-0.8% to 0.2-1.0% to line up with the low point in yields during the Italian political flare-up. We went underweight Italian bonds in April and moved to overweight subsequently in two steps when valuations jumped from expensive to cheap.
- Sentiment: Price momentum faded from positive to neutral, but the overbought contrarian signals simultaneously dropped out of the equation, pushing the overall score into modestly positive territory. Sentiment for core and peripheral government bonds has been very volatile, moving in opposite directions to respectively overbought and oversold levels.
- Conclusion: We continue to favor eurozone financial markets over U.S. markets in particular. The push from strong fundamentals, relatively attractive valuation and supportive monetary policy will likely combine to outweigh the pull from increased political risk. We have moved to an outright overweight position in Italian government bonds after the sell-off on attractive valuation and oversold sentiment signals.