Failure to launch
Europe’s long anticipated growth rebound remains just that, anticipated. Growth indicators are lackluster and persistent low inflation has the ECB pushing rate hikes further into the future. Bond market expectations for inflation in five years’ time have fallen to a record low of 1.2% in mid-June.
We’re not bearish on Europe, but the one-off factors that depressed growth are taking longer to turn around than we had expected. These include the new emissions-testing regime that caused a collapse in German automobile production, the political turmoil in Italy, Brexit uncertainty, the U.S.-China trade dispute and the gilets jaunes political protest movement in France.
Industry-based data suggest the recovery in automobile production is underway. The widening of the trade dispute, however, is a drag on business confidence. The negotiations on a U.S.-European Union (EU) trade deal are making little progress, President Trump is keeping open the threat of tariffs on motor vehicles, and the U.S. has threatened additional tariffs on European exports in response to a long-running dispute over EU subsidies to the European aerospace corporation Airbus.
Adding to the list of concerns is the uncertainty around Italy. Opinion poll support for the right-wing populist Lega party, according to published local surveys as of mid-year, is running far ahead of its coalition partner, the left-wing populist Five-Star movement. An election before year-end looks increasingly likely. The spread between the yield on 10-year Italian bonds and 10-year German bunds has started widening. At 260 basis points at mid-year, the spread is still well below the peak of 330 basis points reached during last year’s crisis. Further political uncertainty and a renewed fight by the Lega with the European Commission over fiscal easing could generate market nervousness.
Fiscal easing should provide a decent tailwind with the European Commission expecting fiscal thrust of 0.4% gross domestic product (GDP) this year. This combined with ECB dovishness and a rebound in German automobile output should put a floor under growth in 2019. The risks, however, have increased and optimism on Europe requires an easing in global trade tensions.
- Cycle: We still expect the cycle to improve over coming months as the impact of one-off events subsides, although this is taking longer than expected. Exports to emerging markets are equal to nearly 10% of Eurozone GDP, which means a further escalation in the trade conflict is a significant risk. Equally, Europe will get a boost from a trade thaw and stands to be one of the main beneficiaries of significant Chinese policy stimulus.
- Valuation: Eurozone equities are close to fair value on our calculations. Core government bonds are long-term expensive. 10-year German bund yields at -0.25% as of mid-June, are essentially as low as they can realistically fall.
- Sentiment: Contrarian sentiment signals are broadly neutral as of mid-June. We see no signs that equities are either overbought or oversold. Price momentum in Eurozone equities is flat.