Investment Strategy:  Fourth Quarter – Specific Market Reviews: Europe

  • In 2017 all economic news was good news but this gloss has been somewhat rubbed away. Nevertheless, GDP growth should still be around 2% in 2018 with profit growth in high single figures, so supportive at least if not the big driver of last year. The Eurozone economy is more geared towards external trade than the other major developed economies and as such has most to lose from a slowing global economy and/or an escalation in the trade wars. This factor is exacerbated for investors by the composition of the European bourses with their predominance of value and cyclical sectors. This makes them particularly vulnerable to disappointing growth numbers, examples being autos which are hurt by trade tensions and the Banks which are still grappling with shaky balance sheets and poor loan demand.
  • The ECB is set to wind down its bond buying and finally exit QE at the end of the year though the shakiness of the economy and the financial frailties of the Banking system make the risk of any policy error all the more 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 may result in 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 far 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 and horse trading regarding the nationality of his successor has already begun.
  • Europe is still struggling to turn the ‘post crisis’ page with Italy along with Brexit reminding investors of the continent’s political instability. Policymakers across Europe remain pre-occupied with immigration and nationalism rather than fiscal and structural reform leaving the EU vulnerable still to systemic bank failure or stress in a large government bond market.
  • Italy’s huge public debt mountain has been a concern for investors for a long time. The threat of a fiscal splurge by the new populist coalition government has caused investors to take fright, sharply pushing up bond Italian government yields over the summer. The recently announced budget at the end of September realised these fears to some extent and could set the Italian government on a collision course with the EU.
  • The MSCI Europe trades on a P/E of 13.5x forward earnings, not expensive but nor the bargain the euro bulls claim, especially if global growth were to slow given the cyclical bias to corporate earnings noted above.

Summary: The ‘great economic recovery’ story is losing some momentum and events in Italy highlight the ongoing dysfunctionality of the Eurozone. Nonetheless, respectable earnings growth and fairly priced valuations provide some support for the equity markets.

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