The eurozone: Stuck in the middle
The eurozone is still enjoying a mid-cycle renaissance, but its financial markets continue to struggle with euro strength. It is stuck between two competing forces. As such, it is an almost perfect exemplar of the global tension we identified between cyclical headwinds and tailwinds. However, the euro headwind is waning as we move into the second quarter of 2018 and the fundamental tailwinds are as strong as ever.
As a rule, when we write about our preferred equity regions, we focus on returns in local currency terms, while our currency views are either explicitly mentioned or covered in the currency segment of this quarterly outlook report. In the case of the eurozone and the euro, we have talked at length over the past few quarters about both the outlook for the currency as well as the impact it was having on our investment stance. In fact, we have combined long positions in both equities and the euro to reflect the positive impact the strong cycle developments were having on both.
That stance notwithstanding, we have been surprised by how much euro strength has weighed on the equity market. This headwind is clearly revealed by the relative performance of small-cap vs. large-cap companies’ shares. The former is less sensitive to currency swings because the bulk of their book of business is conducted regionally and therefore denominated in euros. By the same token, they are also more sensitive to regional economic developments.
Since the start of 2016 small-cap stocks have outperformed large caps by almost 14 percentage points in euro terms (see chart below). Additionally, eurozone small caps have outperformed global small caps by almost six percentage points in local currency terms. That means that small caps were able to outperform in the face of an 8% rise in the trade-weighted euro exchange rate (and a 17% rise vs. the U.S. dollar). Clear evidence in our view that the strong fundamentals matter, but in the case of large-cap equities were simply outgunned by the currency effect.
Eurozone small-cap stocks outperform amid competing cyclical forces
Source: Thomson Reuters Datastream, as of March 12, 2018.Indexes are unmanaged and cannot be invested in directly. Performance quoted represents past performance and should not be viewed as a guarantee of future results.
However, large caps being outgunned was not just the result of euro strength. In relative terms, another headwind came in the form of the fiscal boost to corporate earnings expectations in the U.S. Although expected earnings growth in the eurozone is still a healthy 9%, it pales in comparison to the 20% in the U.S. However, we believe this relative cloud comes with a silver lining. As the fi scal boost starts to be felt, we expect the Fed to become more hawkish to prevent the economy from overheating and to help stave off the threat of inflation. This in turn should support the U.S. dollar, and by extension slow down or maybe even halt the euro rally. In any case, with the EUR/USD exchange rate near 1.24 as of March 13, 2018, most of the damage for the eurozone equity market from a strong euro is probably in the rear-view mirror.
Our optimism regarding eurozone economic growth, financial conditions, corporate earnings and political risk remains in place. Gross Domestic Product (GDP) growth is currently at the upper end of our 1.8%-2.4% band, consumer and producer confidence is strong, and credit growth is rising. Corporate earnings continue to be well-supported by both revenue growth and rising margins.
Political risks are still there, but so far have not materialized. In Germany a new “grand coalition” government was formed by two mainstream political parties, while in Italy there was no outright victory for the Five Star Movement populist political party. Of course, we are closely watching how Italy will manage its coalition talks, but in the short term we see only limited market risk. Finally, the Brexit negotiations between the UK and the European Union (EU) are moving forward, albeit at a dangerously slow pace. We still expect an agreement will be reached to implement a two-year status-quo transition period, but it is clear that the Irish border is a dangerous sticking point. We hope UK Prime Minister Theresa May will reverse course and opt to pursue a new customs union with the EU to resolve that problem.
- Business cycle: Strong GDP growth at the upper end of our band has allowed us to upgrade our business cycle score. We expect the ECB to stay accommodative and dovish this year. Corporate earnings growth of approximately 5%-10% is robust.
- Valuation: Eurozone equity valuations are neutral while core government bonds are long-term expensive. Our expected range for core bond yields at 0%-0.8% is unchanged, although we would be surprised to see the low end of that range again. Still, a significant breakout remains unlikely given ECB bond purchases and lack of inflation. We remain neutral in peripheral1 bonds.
- Sentiment: A combination of positive price momentum and overbought contrarian signals have kept our sentiment score for eurozone equities in slightly negative territory. Sentiment for core and peripheral government bonds has gone from neutral to positive as negative momentum was overruled by oversold contrarian signals.
- Conclusion: We continue to favor eurozone financial markets, particularly over U.S. markets. Strong fundamentals and relatively attractive valuation underpin our view, while sentiment is currently not a differentiator.
1 Europe’s peripheral countries Portugal, Spain, Italy, Ireland and Greece are generally seen as less developed than the region’s core counterparts.