The eurozone: Markets are closing the gap
In the past quarter, eurozone markets started to close the gap between strong fundamentals and weak relative performance. A "good news" show coming from the economy, political developments, earnings growth and monetary policy pushed markets higher. Although this rally has stretched near-term sentiment, we expect the eurozone to continue to do well in the medium term.
The good news show
From a eurozone perspective, the past few months have resembled a good news show. Virtually nothing went wrong and all the important stuff went right. Of course, the most important piece of good news came out of France, where Emmanuel Macron won the presidency and his party En Marche won an absolute majority in the Assembly. Not only did this eliminate the tail risk of a win for the euro-skeptic Marine Le Pen, but it also highlighted the potential of a political renaissance in the eurozone.
A refurbished Franco-German engine can revive important reforms on the banking union and permanent stability mechanism, for instance. And in the face of Brexit, unity between France and Germany is important to safeguard the future of the monetary union. Obviously, Brexit itself is still somewhat of an economic risk, especially after the Tories lost their majority in the House of Commons. However, that risk lies more with the UK, and the political unity that Brexit is fostering amongst EU members is probably more valuable than any economic disruption Brexit may cause. Finally, if Matteo Renzi can win the Italian elections in 2018, it is very likely that eurozone political developments will become a source of upside potential, which is a big positive change from representing downside risk.
On the monetary policy front, the news was also good. ECB President Mario Draghi made it clear he will be slow to remove the amount of stimulus, eliminating fears of an abrupt end to quantitative easing at the end of 2017. In line with our expectations, a quick decline in inflation helped underline his position that inflation was still being driven by transitory forces as opposed to sustainable drivers. There is simply still too much slack in the eurozone economy to worry about inflation.
On the economic growth front the news was also good. GDP growth continues to accelerate and is close to 2%. Consumer and business confidence are riding high and credit growth is positive. As a result, consumer spending, corporate investment, and housing are all doing well. On top of this, companies are reporting strong earnings growth driven by both margin and revenue expansion.
In the face of such a good news show, it was nice to see eurozone markets finally pushing hard to close the gap between weak relative performance and strong fundamentals. In the very near term such a rally is risky because a sentiment reversal is possible, but in the medium term we expect the fundamental tailwind to continue to support eurozone markets.
EMU* economic surprise index vs. equity performance
Source: Thomson Reuters Datastream, 6/19/2017.
*EMU refers to the Economic and Monetary Union, which includes the 19 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 15% adds up to a positive business cycle score.
- Valuation: Eurozone equities have pushed into slightly expensive territory, but are still cheap relative to the U.S. In eurozone core government bonds we remain neutral with yields still in our range of 0-0.5%. Peripheral bonds have done well lately and yields have returned to our range of 1-2%. However, in our view, there is still a smidgen of value left with spreads slightly above fair value.
- Sentiment: A combination of positive price momentum and overbought contrarian signals have kept our sentiment score for eurozone equities in negative territory. Sentiment for core government bonds is still neutral. The rally in peripheral bonds means they are no longer oversold but they are not yet overbought either.
- Conclusion: The strong rally in Q2 has pushed eurozone equity valuation and sentiment down, which means we need to be careful in the very near term. In fact, over the past few weeks eurozone equity outperformance has already paused. However, beyond that nearterm pause we continue to believe in the reflation trade where strong fundamentals and attractive relative valuation drives markets higher. The eurozone is on solid footing both economically and politically. Of course, with respect to the latter, we continue to monitor developments in Italy. The next, yet unscheduled, election is still most likely a 2018 story, and in the meantime we were happy for the sake of the eurozone to see that the euro-skeptic Five Star Movement lost the local elections in April. But because of Italy’s importance to the eurozone, we must be vigilant.