It’s too late to be pessimistic about Europe
By Kerry Craig, Global Market Strategist, JP Morgan Asset Management
To paraphrase Al Gore, it’s too late to be pessimistic about the eurozone. If we overlook Greece for now, the situation is generally improving. In fact, the prolific pessimism has confounded many forecasters as the latest string of economic data has actually beaten expectations—most notably the recent GDP figures for the final three months of last year.
The eurozone economy expanded by a better-than-expected 0.3% between September and December of last year, topping figures for the previous three-month period. But while the region’s economy appears to be gaining momentum, the picture looks very different from country to country.
Germany’s economy expanded by 0.7% over the quarter—double expectations—raising hopes that the region’s engine maybe starting to fire on all cylinders once again. Spain recorded the same rate of growth—its best performance in seven years—while the Netherlands and Portugal also contributed to the single currency bloc’s economic outperformance.
There is clear evidence of increasing levels of domestic consumption as the benefits of weaker energy prices and slowly improving employment levels start to filter through to growth figures. But the news is not so rosy everywhere. France managed only a very marginal expansion, while Italy’s economy essentially flat-lined. However, even these two countries managed to beat the pessimistic forecasts. The turbulent situation in Greece caused the country’s economy to contract slightly at the end of 2014 after three steady quarters of growth.
Markets are not as pessimistic. The broad STOXX 600 Index of European companies is up 10% this year, when dividends are included, as the economic backdrop becomes brighter. The 6% fall in the value of the euro vs. the greenback since the start of the year should continue helping to create the inflation that the European Central Bank (ECB) is so desperate to achieve.
More importantly, it should also help raise inflation expectations, as well as boosting corporate earnings from outside the euro area. Combined with lower energy costs, looser credit standards, improving loan demand and reduced fiscal consolidation, this provides a basis for stronger market performance.
It could be argued that markets are only reacting to the ECB’s imminent bond-buying spree. To a certain degree, this is true as investors have no doubt equated the quantitative easing (QE) undertaken by the Bank of England or the US Federal Reserve to higher markets. The “portfolio balance effect” should see equities—particularly the higher-yielding ones—continue to benefit as investors look to replace lost income streams.
The impact on equities will be both direct as investors sell bonds and buy equities, and indirect, as firms take advantage of the demand for corporate bonds to issue new debt at more attractive market rates. This new debt could be used to retire older, more expensive financing. Alternatively, it could be used to return capital to shareholders, pushing markets higher by increasing dividend payouts or share buybacks.
The more dramatic effect of QE is its impact on depressing the value of the euro: around half of the earnings of companies listed in the MSCI Europe Index come from outside of the euro areas. The market will have already priced in much of the ECB action into the euro ahead of the January announcement, so the direct effect on foreign-denominated earnings should be apparent in this year’s earnings figures.
At the time of writing, just over half of European companies had reported fourth-quarter earnings figures, with earnings per share growth of 5%. This means they are on track to achieve a second quarter of strong earnings, which is key to justifying not just market levels, but valuations too.
With the eurozone looking set to build on the positive economic momentum of the final three months of 2014, investors should consider a risk-on approach to the region. What’s more, equity markets no longer look as attractive as before, making active selection crucial. Cyclical stocks, particularly the consumer discretionary sector, are one way to play the expected increase in domestic demand. Unfortunately, politically driven volatility seems a near certainty throughout 2015.