Eurozone outlook: Reflation is winning

Eurozone economic growth has been strong and its financial markets have started to rebound. In the broader context of continued monetary stimulus, we think it is becoming ever more certain that reflation is winning. When markets see the same, we expect the rebound will accelerate and the gap with strong fundamentals will close.

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Mind the gap

Since the financial crisis of 2008, the eurozone has been in the midst of an epic strugglebetween deflationary and reflationary forces. As soon as ECB President Mario Draghistarted to hint at an asset purchase program in 2014, we began making the case thatthe reflationary forces would win, supporting both economic growth and financialmarkets. By and large that thesis has played out and reflation is winning, although theimpact on eurozone growth has been larger and more reliable than the impact on markets.However, we expect that gap will close over time and markets will catch up, keeping uspositive on eurozone assets.

One worry that clients have been querying us about is whether the ECB can remainan important driver of reflation in the face of quickly rising inflation. We think it can forseveral reasons. First, the rise in inflation is currently driven by transitory forces, mostnotably a rise in energy prices. However, we believe the impact of that rise on inflationwill quickly fade from Q2 2017 onward. Second, for the ECB to start worrying aboutinflation, it will need to see a pickup in sustainable drivers of inflation such as wagegrowth. With the unemployment rate still close to 1% above NAIRU2 there is plentyof slack left in the labor market, meaning rising wage growth is some ways off.

EMU* economic surprise index vs. equity performance

Source: Thomson Reuters Datastream, 3/16/2017.
*EMU refers to the Economic and Monetary Union, which includes the
19 eurozone states as well as non-euro European Union states.

Only when economic growth accelerates to 2% or higher and credit growth continues to rise do we see the ECB trimming back monetary stimulus. That is currently not our base-case scenario as we expect economic growth around 1.5 – 1.8% and continued but modest credit growth. That is enough, in our view, to push the unemployment rate toward 9% in 2017, but not enough to trigger a meaningful pickup in wage growth.

Why we continue to fade political risk

As expected, the Dutch elections turned out to be a red herring. For all the noise around the likelihood of a victory for the far-right PVV political party, the truth was it never came close to power, even at the peak of its polls. Parliamentary systems make it hard for extreme left-wing or right-wing parties to gain power because coalition governments are the norm. By the same token, we don’t worry about the German elections in September. In fact, that election looks like it will become a battle between a cautious pro-European Chancellor Angela Merkel and a bold, very pro-European Martin Schultz, who formerly served as president of the European parliament. What we may lose in stability if Merkel loses we likely will gain in a more supportive pro-European stance, with some fiscal stimulus on top. Either way, it's not a bad outcome for Eurozone markets in our view.

Of course, the comfort blanket of a parliamentary system is not in place for the French presidential elections in April/May. That election continues to be very important because of the enormous amount of power the French president wields. Since François Fillon is still caught in a continuing scandal, it now looks likely that former investment banker Emmanuel Macron and populist candidate Marine Le Pen will win the first round. And second round polling still shows Macron to be a heavy favorite. That, combined with the knowledge that the euro is still very popular in France, the refugee crisis is over, and rising inequality is much less of a problem. Therefore, in our view, the outlook is good and we continue to advocate fading market volatility on election worries.

Strategy outlook

  • Business cycle: Expected GDP growth of 1.5%, combined with loose monetary policy and corporate earnings growth of 5 – 10%, adds up to a positive business cycle score.
  • Valuation: Eurozone equities are considered neutral value in an absolute sense and outright cheap relative to the U.S. We remain neutral on eurozone government bonds, with yields still in our range of 0 – 0.5%. We see some value in peripheral bonds where yields have risen slightly above our range of 1 – 2%, but we will trade around the French election to mitigate risks
  • Sentiment: A combination of positive price momentum and overbought contrarian signals has pushed our sentiment score for eurozone equities into negative territory. Sentiment for core government bonds is still neutral, while Italian bonds remain oversold.
  • Conclusion: We are sticking to the reflation trade, expecting the gap between strong fundamentals and lackluster markets to close when investors realize the eurozone is on solid footing both economically and politically. Of course, we will continue to monitor the political risks, but we remain optimistic that there will not be any surprises in the eurozone next year along the lines of the Brexit vote outcome or U.S. President Trump’s victory.

2 NAIRU is the acronym for non-accelerating inflation rate of unemployment, and refers to a level of unemployment below which inflation rises.

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