Wealth Insights (July 2017)

Europe Is In Early Stages Of Recovery

Political tail risks have receded, at least for the time being, on the back of Macron’s decisive victory in the French elections. However, political risks remain in the medium term with German and Italian elections on the horizon. However for now, the focus will likely shift towards the improving economic prospects and fundamentals in the region.

Positive macroeconomic outlook

By and large, the macro-economic picture in the Eurozone seems fairly optimistic. Recent quarterly growth data remains solid and deflation risk has largely receded as evidenced by rising headline producer and consumer price inflation. Confidence indicators such as the manufacturing and non-manufacturing Purchasing Manager Indices (PMIs) are showing the best business conditions since before the start of austerity programmes in 2011. Anything above the 50-point line is a sign of expansion, so the PMIs send a positive message on growth in the Eurozone.

That said Europe is still in the early stages of a multi-year economic recovery cycle with plenty of slack observed in the labour and factor markets. While the unemployment rate has gradually dropped from its peak of about 12 per cent in 2013 to 9.5 per cent in March this year, it still remains elevated by historical standards. Also, industrial production, whilst on a steady and gradual uptrend, is still far from pre-crisis levels, pointing to some slack in capacity utilization as well.

Nevertheless, supportive business conditions and buoyant consumer sentiment combined with still accommodative monetary policy and a healthier financial system should keep the economy growing towards full employment.

ECB likely to take baby steps

Of concern to most investors is the possible timing of the European Central Bank’s exit from further monetary policy accommodation given the stronger growth outlook. Indeed in the recent June policy meeting, the ECB governing council has acknowledged recent economic progress, judging the risks to the growth outlook to be “broadly balanced” and removed the commitment to cutting interest rates. This sets the stage for the ECB to signal exit from its asset repurchase programme before the end of this year and to begin tapering asset purchases sometime in 2018.

A concern for some members of the governing council is the noticeably weak and trendless core inflation data which is often deemed to be more reflective of the underlying inflationary pressure in the Euro area. In addition, wages continue to show little growth despite the substantial decline in unemployment. Headline inflation had spiked earlier in the year due to higher commodity prices, but even that is now fading as base effects recede.

Concerns over inflation suggest, if anything, the ECB will likely move slowly to remove accommodation and remain fairly circumspect so as not to disrupt the on-going economic progress as slack in both the labour and factor markets continue to recede. Indeed, experience with the U.S. suggests every policy decision from here will be heavily telegraphed and couched with statements highlighting flexibility in policy-making and a willingness to reverse course should the need arise.

Conducive outlook for European assets

On balance, the macro environment remains conducive for European risk assets. The effects of favourable macro conditions have begun to filter down into corporate earnings, which have seen steady improvement over the past year. Also, for the first time in 5 years, year-end Earnings-Per-Share (EPS) estimate for the MSCI Europe index is being revised upwards. Such a set-up is usually conducive for risk assets.

We had upgraded our view on European stocks from negative to neutral in May this year and look to maintain that position. While European stock valuations remain stretched versus its 10-year history, it still cheaper when compared to U.S. stocks from a price-to-earnings basis. At the same time, the asset class offer the highest dividend yield relative to other regional markets which can be a good source of returns in fully-valued investment environment.

The disastrous U.K. elections and the resolution of Banco Popular could cause some uncertainty in the near term but these look contained and are unlikely to derail the wider economic recover. Meanwhile, Greece continues to be a side show in an otherwise stable region.