Investment Strategy:  First Quarter – Specific Market Reviews: Europe

  • The European growth story has disappointed, Eurozone Q3 GDP growth was 1.7% y/y compared to 2.1% in the previous quarter. Growth in Italy was stagnant and the mighty German economy actually shrank by 0.2% in the quarter between July and September, the first contraction since 2015 as exports sagged to China and the emerging markets where firms listed in Europe earn a third of their profits. Nor is there a great European structural story with an ageing population, fragmented markets and a preponderance of ‘old’ industries (autos, chemicals, machinery) and a scarcity of world class digital firms. At the political level there is still minimal momentum towards increased economic integration and financial co-operation with the rise of populist parties driving the EU countries further apart rather than closer together. The ‘great recovery’ bulls aren’t so plentiful as they were a year ago!
  • Six years after his famous ‘do whatever it takes’ speech Mario Draghi finally ended the ECB bond buying QE programme in December. The shakiness of the Eurozone economy and the frailties of the banking system make the risk of policy error acute. The ECB has been such a huge buyer of European bonds (far bigger in proportion than the US and UK) that ending the QE programme runs the risk of a rise in both bond yields and the euro. This could knock the stuffing out of the Eurozone economy and set off a widening of bond spreads in the periphery precipitating another Greek/Italian crisis. Interest rate rises thus remain on the distant horizon with no expectation of any rise before October 2019 when Draghi steps down from his term as President of the ECB. The speculation regarding the nationality of his successor has already begun.
  • The Italian budget wrangle continues, though some accord appears to have been reached with the passing of a revised budget at the end of December. Like Greece in 2011, Italy has too much debt and a populist government who wants to spend more, much to the annoyance of the EU. Unlike Greece though it has an annual budget surplus before interest payments, an average bond maturity of around seven years and much of the debt is held by domestic investors. In truth, a mildly expansionary stance arguably makes better sense than the EU’s insistence on austerity given the stagnation of the Italian economy over the last 20 years. Crucially, and again unlike Greece, Italy considers itself ‘too big to fail’ not least because of the solvency risk to the Italian and wider European banking system of a collapse in the Italian bond market. The risk is that the markets lose faith in the ability or willingness of the EU to fund any further flouting of their budget rules with the indicator of market sentiment being the gap between German and Italian bond yields.
  • ‘Mutti’ is leaving the kitchen. Angela Merkel, the de facto leader of the EU for the last 13 years, has stepped down as leader of her CDU party following a series of harrowing electoral setbacks. In theory she could remain Chancellor until 2021 but no-one is expecting this as the two jobs belong together. After a decade of sober and admirable leadership she is the lamest of ducks at a time the EU needs a strong hand on the tiller more than ever with Brexit, Italy, the ‘yellow vest’ protests in France, the rise of populist parties everywhere and the global trade war. Merkel’s demise is somewhat ironic given that the country has dealt well with the huge influx of refugees in 2014 and 2015 that was the catalyst for her fall from grace. The dissatisfaction is more about perception; after two decades the big Centrist parties feel out of date and out of touch, losing support to the populist and more focused parties, the centre-left Greens and the right wing AfD. This, of course, is a global not just a Germanic trend. The sense post Merkel is that Germany will become more introverted and less likely to take a pan-European and global lead.
  • The fundamentals underpinning the market look less solid than a year ago but this arguably has already been discounted in stock prices with the MSCI Europe index trading on a reasonable looking forward P/E of 12.5x.

Summary: Eurozone growth disappointed last year and European politics remain as dysfunctional as ever. European stock markets have a cyclical bias so global growth concerns and trade war tensions will be the major driver of markets.

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