The eurozone: The euro versus everything else
From the perspective of financial markets, the third quarter of 2017 is best described as "the euro versus everything else." Tailwinds in the form of continued strong economic growth, favorable politics and robust earnings were neutralized by a single headwind: a rising euro exchange rate. Looking ahead, we expect the balance between these two forces to tilt back in favor of the fundamentals, supporting eurozone assets.
Headwinds and tailwinds
The "good news show" that we reported in our mid-year report has continued over the past few months. Economic growth remains strong and forward-looking indicators such as producer and consumer confidence remain at elevated levels. Our expectation for eurozone gross domestic product (GDP) growth is unchanged at 2% and we would not be surprised to see it reach slightly higher than that for 2017. On the earnings front, eurozone companies remain on track to deliver 10-15% growth for the year. Margin expansion in particular is a boon.
In our mid-year report, we also talked about a change in how political developments were impacting financial markets. With President Emmanuel Macron’s victory in France and the associated advent of a renewed Franco-German engine at the heart of the eurozone, political developments shifted from a source of risk to a source of upside potential. That trend has continued with Chancellor Angela Merkel seemingly cruising to victory in Germany, according to German election polls in mid-September, and, more importantly, a noticeable turn away from euroskepticism in Italy. Macron’s defeat of Marine Le Pen sent a loud and clear message: in the eurozone it does not pay to be a euroskeptic. In summary, the fundamentals were and are expected to continue to be clear tailwinds for eurozone markets.
Even though the tailwinds remained in place, their impact on financial markets shifted meaningfully from Q2 to Q3. Whereas equity markets were pushed higher in Q2, in Q3 the euro exchange rate was the main beneficiary. Strong economic growth against a backdrop of low inflation propelled the euro higher while a long spell of weak inflation simultaneously pushed the U.S. dollar down. In doing so, a headwind was created for eurozone markets. After all, eurozone companies derive 50-60% of their profits from abroad and a stronger currency diminishes their value. This dynamic is shown in the chart on the next page.
Expectations around future monetary policy played an important part too. Statements by ECB President Mario Draghi were perceived to be slightly hawkish and markets worried he might taper the amount of bond purchases more aggressively than previously anticipated. Looking ahead, we expect those worries to abate. Although bond purchases will likely be tapered towards 30-40 billion euros per month in 2018, this still constitutes a very easy monetary policy. Draghi has stated he will be patient and prudent in removing monetary accommodation. He understands that both the economic recovery and a return to 2% inflation are contingent on it, particularly given how much slack there still is in the eurozone economy.
Eurozone equities & euro exchange rate
Source: Thomson Reuters Datastream, as of September 13, 2017.
EMU refers to the Economic and Monetary Union, which includes the19 eurozone states as well as non-euro European Union states.
Performance quoted represents past performance and should not be viewed as a guarantee of future results. Indexes are unmanaged and cannot be invested in directly.
- Business cycle: Strong GDP growth, loose monetary policy and corporate earnings growth of approximately 10-15% add up to a positive business cycle score.
- Valuation: Eurozone equity valuations have gone back to neutral from slightly expensive as earnings outpaced prices over the third quarter of 2017. In eurozone core government bonds we remain neutral with yields still in our ‘old’ range of 0-0.5%. Looking ahead, we decided to widen our range to 0-0.8% due to ECB tapering of bond purchases. Peripheral bonds continued to do well over the third quarter and we neutralized our positions in French and Spanish bonds when spreads tightened to our target levels. We still see a bit of value in Italian and Portuguese bonds so we maintain slightly overweight positions there.
- Sentiment: A combination of positive price momentum and overbought contrarian signals have kept our sentiment score for eurozone equities in negative territory. We see sentiment for core and peripheral government bonds as neutral.
- Conclusion: In our mid-year report, we highlighted that near-term caution was warranted given overbought sentiment and slightly expensive valuations. This turned out to be good advice as the subsequent rally in the euro exchange rate turned into a formidable headwind for equities and relative performance waned. However, looking ahead we expect the balance to tip in favor of tailwinds from strong fundamentals and attractive relative valuation. And, similar to what we saw in Q2, that should drive markets higher. Watchpoints for this region continue to be ECB policy and political developments in Italy. Regarding the latter it is noteworthy that previously euroskeptic parties are toning down their rhetoric, learning the lessons from Macron’s victory over Le Pen in France.