European Equities – should you hold your nerve?
Despite last year’s dry run, financial markets have again been disregarding political uncertainty. Most equity markets have enjoyed double-digit gains since the Brexit vote, typical safe havens have been left in their wake and cross asset volatility has dropped towards historical lows. Are investors right to be so calm?
Determined doves and economic green shoots
Dovish central banks continue to soothe investors’ nerves. Macroeconomic news has improved, and a global recovery looks to be well underway. This especially true in the eurozone where the signs are clear to see.
March PMI survey results reached their highest since the Great Financial Crisis and are, rather optimistically, suggesting growth of around 3% in Europe this year. Labour market conditions are also improving, as is confidence. Consensus estimates for growth in 2017 have been revised upwards continuously since last summer. We hold to our prediction of a rate of 1.8% for eurozone growth in 2017.
The missing link
Progress on activity is clear, but evidence inflation is gearing up is scarce. Inflation expectations have eased, oil base effects are waning (greater US production is delaying the rebalancing of the market) and wage growth is yet to really gain traction. Some inflation could be imported from a weak euro and a firmer credit uptake could help. Core inflation could end the year at around 1.1%, but that’s unlikely to be enough to shift the ECB’s stance.
Those frail inflation prospects should keep the ECB dovish for now. QE should endure until year end, with Mario Draghi and team resisting the taper temptation until 2018 at the earliest. Base rates should turn positive by 2020 while deposit rates could be less negative sooner. ECB support bodes well for Europe’s credit markets given corporate bonds represent the deepest pool of assets at the central bank’s disposal. Should sovereign yields jump, the picture might not be so rosy.
Further progress towards reflation is likely and should aid corporate margins. Companies seem to be regaining pricing power without facing any real pressure to raise wages, which is a good omen for earnings. Little wonder flows into European Equity ETFs have been strong this year as investors wary of slimmer pickings in the US have sought out more realistic valuations. There could yet be a great deal of upside in eurozone equities, especially for single country indices, but the politics still call for caution despite the relief that greeted the result in France.
Unanswered questions
The results of the first round are likely to unwind most of the election risk premium, but other tests lie ahead, including legislative elections in mid-June. For now, we expect further support for European equities, banks and reflation-related areas like retail, automobiles and construction. Don’t however take it for granted that possible gains from ongoing will be realised in full.
Conditions appear ripe for EMU households to spend more as economic activity picks up and labour markets strengthen. Building activity should accelerate now recovery is entrenched. Public investment will focus heavily on infrastructure, while households should enjoy the ultra-low borrowing cost environment and positive moves in real estate prices.
Eurozone banks seem to have overcome most of the structural and regulatory hurdles of recent years and are becoming interesting tactical opportunities. Italy, where valuations are attractive and financials make up around a third of the Index, could benefit.
Waiting for the light to change
A market-friendly victory, and a legislative majority, in the second round could green light a catch up of the CAC 40 over the DAX and even versus the CAC Mid 60, which has no exposure to banks. In the long run, however, such an outcome could lead to reduction in corporate tax rates, and a possible tailwind for the smaller companies in the CAC Mid 60.
Elsewhere, Dutch companies look set to enjoy some impressive earnings growth, while their Irish peers could be beneficiaries of the Brexit uncertainties across the water.
The Brexit burden
While we are positive on eurozone equities, we can’t say the same for their UK counterparts. The UK market seems to have so far shrugged off the burden of Brexit, while higher commodity prices and weaker sterling could add some support. We do however believe investors are unduly complacent about the risks to British companies’ earnings.
Don’t bank on (all) bonds
We’re neutral for now, but eurozone bonds do look expensive. Even a Le Pen loss comes with risks because it could prompt investors to unwind the safe-haven trades that drove bund yields down to near zero. However unlikely, better-than-expected economic growth and inflation data could still tempt Draghi and his doves to taper their bond-buying programme later this year. The EU’s more orthodox Northern countries certainly hope so.
Trade wisely once the French elections are fully behind us. It may focus minds more sharply on the ECB’s plans to exit its quantitative easing programme, making the prospects for bonds a little more bearish as we drift beyond the summer.
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All data: Lyxor Cross Asset Research & SG Research, April 2017. Opinions expressed are as at April 2017.
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