The eurozone: Mid-cycle renaissance
The eurozone is in the middle of a mid-cycle renaissance, both economically and politically. Reflation combined with the refutation of populist movements in the region have laid the foundation for a self-sustaining recovery that could last for years to come. This environment should provide a strong tailwind to eurozone financial markets, which we continue to favor.
Why it can last
In our 2017 annual outlook we talked about being optimistic about eurozone growth, financial conditions, corporate earnings and political risk. Those strong fundamentals, which were the product of reflationary forces outweighing deflationary ones, would in turn support eurozone financial markets.
Looking back, it is interesting to see we were simultaneously not optimistic enough about how much those fundamentals would improve and too optimistic about their impact on financial markets. Growth and earnings have both come in slightly higher than expected, financial conditions improved in line, political risks turned into opportunities, and yet relative equity market performance is slightly down. In our third quarter 2017 outlook report we explained why: a rising euro has been a formidable headwind in a market environment characterized by strong absolute performance.
Looking ahead we expect eurozone financial markets can overcome that headwind, and the economic and political renaissance will once again drive both relative and absolute performance. We also expect eurozone economic growth in 2018 to stay strong at 1.8%-2.4%. Economic sentiment stands at a 17-year high in November 2017, according to the European Commission, and strong global growth is a boon for exports. Real economic activity such as industrial production and retail sales is expanding robustly and — in light of easy financial conditions and high levels of producer and consumer confidence — should continue to do so.
Eurozone retail sales, industrial production & GDP growth
Source: Thomson Reuters Datastream, through Q3 2017.
What could go wrong
The risks around our outlook are threefold. First, when it comes to the eurozone, political risk is always lurking around the corner. Currently, we are worried about both the troubled state of the Brexit negotiations and the Italian elections in Q1 2018. With respect to the former, we still expect an agreement will be reached to implement a two-year status-quo transition period, which should minimize the economic fallout from Brexit. However, a complete breakdown in talks cannot be dismissed as a possibility, and severe trade disruptions with the UK could wreak havoc on the region’s economic growth. With respect to the Italian elections, we are mostly focused on the risk of a Euroskeptic bloc taking power. However, Euroskepticism has not been a winning strategy in recent elections and is notably in decline in Italy. Even more, the recent electoral reform makes it unlikely the populist Five Star Movement can win an outright majority on its own.
Second, there is the risk that financial conditions unexpectedly tighten materially. A combination of higher bond yields, higher credit spreads, lower equity markets and a rising euro would materially weigh on the eurozone recovery. It is hard to foresee what could trigger such an event now that the European Central Bank (ECB) has committed to continued bond purchases, but a global selloff in financial markets triggered by an inflation scare could potentially do the trick. This is not something we consider likely.
Third, a slowdown in global growth triggered by China is a risk. With the National Congress of the Chinese Communist Party behind it, China might decide to prioritize reform over growth and deflate its economy a bit. That would pose a headwind to the eurozone and, although there are no signs this is happening, it is something we are monitoring.
- Business cycle: Strong GDP growth, loose monetary policy and corporate earnings growth of approximately 5-10% equates to a positive business cycle score.
- Valuation: Eurozone equity valuations are neutral in late 2017 while core government bonds are long-term expensive. However, for 2018 we expect core bonds to remain rangebound at 0-0.8% due to ECB bond purchases and lack of inflation. Peripheral bonds have done very well in 2017, which has pushed their valuation levels to neutral. As such, we have neutralized our overweight position.
- Sentiment: A combination of positive price momentum and overbought contrarian signals have kept our sentiment score for eurozone equities in negative territory. However, sentiment for core and peripheral government bonds is neutral.
- Conclusion: We continue to favor eurozone financial markets over U.S. markets in particular. Strong fundamentals and relatively attractive valuations underpin our view while sentiment is currently not a differentiator.