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While by no means conclusive in laying to rest the threat posed by anti-EU parties, the Dutch, French and German elections of 2017 are encouraging leaders in Paris, Brussels and Berlin to press ahead with greater political and economic integration, rather than loosen existing ties. Even as the Brexit negotiations grind slowly on, the next big test for the European dream is the Italian general election which is scheduled for May 2018 at the latest, although the protracted nature of the German coalition talks after September’s ballot are an unwanted complication.
If the EU’s politics continue to confound the doubters by remaining relatively calm, its economies are doing so by continuing to grow, even as the bloc’s banks remain fragile. Greece is by no means out of its debt mire, and neither is Italy, but Spanish unemployment stands at seven-year lows, Standard & Poor’s once more gives Portuguese Government debt an investment-grade rating (after an upgrade to BBB- from BB+ in September)
The combination of (relatively) stable politics and economics is boosting the euro and the EU’s financial markets too, although they must still confront the prospect of the European Central Bank one day withdrawing the monetary policy artillery which President Draghi has deployed to great effect since 2012. The ECB will throttle back its monthly Quantitative Easing (QE) programme for a second time come January, to €30 billion from €60 billion, although the scheme will run to at least September.
Economics
The European Central Bank has just one mandate – price stability (unlike the US Federal Reserve which must juggle both inflation and employment). However, just like the US Federal Reserve and Bank of Japan, the Eurozone’s central monetary authority is struggling to reach its 2% target, although it came tantalisingly close at the start of 2017, helped by a weaker euro and a stronger oil price.
The ECB is still undershooting its 2% inflation target
Source: Eurostat
Unemployment remains far too high for comfort across many members of the EU-28 region, although the headline rate has declined to 7.5% from the 11% record-high seen in February 2013. Even if the Spanish jobless rates stand at a seven-year low of 16.4% no-one can pretend that is acceptable.
The EU’s banks also remain a cause for concern. Despite protestations to the contrary in the autumn of 2016, Deutsche Bank went to shareholders cap in hand in spring 2017 and raised €8 billion via a rights issue to shore up its balance sheet. Italy found a cute way to circumvent state bail-out rules when it injected €5.4 billion into the ailing Banca Monte Paschi di Siena in summer 2017 and offered up to €17 billion more to clean up Banca Popolare di Vicenza and Veneto Banca. And in Spain, Santander had to step in smartly and buy Banco Popular (where neither shareholders nor bondholders were bailed out) and the country’s eighth biggest lender, Liberbank, began to wobble as summer turned to autumn as its share price plunged.
Yet for all of these three concerns, the EU provided perhaps the single biggest macroeconomic surprise of 2017. Growth proved stronger than expected, as German industrial confidence powered ahead and France, Spain and Italy also put up an improved showing, with Rome’s economy reaching the dizzying heights of 1.8% year-on-year GDP growth in the third quarter, faster than the UK’s 1.5% rate of progress.
Mario Draghi’s 2012 promise “to do whatever it takes” to preserve the EU and the euro seems to have far more power than any fears over what Brexit may mean – and homeowners and landlords in Frankfurt, Paris, Amsterdam and Brussels are already licking their lips at the prospect of financial services staff relocating as they leave the City of London to keep passporting rights and access to EU markets come 2019 (if not before).
For what its forecasts are worth (which admittedly over the past few years has been not very much) the International Monetary Fund expects GDP growth for the EU of 1.8% in 2017, in line with the steady improvement seen since the debt-crisis-inspired downturn of 2012-2013 and the euro’s gains in 2017 against both the pound and the dollar reflect this gathering optimism, even some ground was given back to sterling toward the end of the year.
The euro advanced against the dollar and the pound in 2017
Source: Eurostat
The single currency has also drawn strength from a gathering belief that the ECB will start to tighten monetary policy. The headline refinancing rate has stood at 0.0% since March 2016 but the central bank has announced a second tapering in its Quantitative Easing (QE), from €60 billion a month to €30 billion, from January onwards.
That does still mean, however, that the ECB is loosening not tightening policy – it is just less loose than before and the bank does not look to be in a hurry to join the US Federal Reserve and actually start to withdraw QE.
The ECB has a delicate balance to strike here. It owns around 40% of the bloc’s aggregate Government bonds – the US Federal Reserve does not come even close to that figure – and with the yield premium available on Eurozone corporate junk (high-yield) bonds relative to US Government bonds at a record low, thanks to QE, it will be interesting to see if any of these issuers stumble back into financial distress, to the detriment of the wider EU economy, once the ECB stops, let alone reverses, its bond buying programme.
Markets
Rather like its economy, the stock markets of Western Europe provided a pleasant surprise in 2017. In total return, sterling terms the benchmark Stoxx 600 ranked fourth among the eight major geographic regions, a welcome improvement after the lowly ranking of seventh last year.
Western Europe has now recorded two consecutive years of double-digit total returns for the first time since 2013.
Western European markets ranked fourth out of eight in 2017
Source: Thomson Reuters Datastream, based on Stoxx Europe 600 index. Total returns in sterling terms, 1 January to 30 November
Three factors look to underpin this turnaround in fortunes:
- The first is the defeats for anti-EU parties in the Netherlands, France and Germany, combined with the prospect for EU-wide and domestic reform outlined by President Macron, who is seeking to improve labour market flexibility, via a programme of changes outlined by labour minister Muriel Pénicaud in August.
- The second the slew of better-than-expected economic data, for which bulls may be tempted to give the credit to the European Central Bank, which continues to move heaven and earth to keep the eurozone project on the road. Low returns on cash and low yields on bonds may also be helping to drive investors toward stocks – just as has happened in the UK, US and Japan, too.
- The third is valuation. European stocks do not look particularly expensive relative to their history – unlike those in the US for example.
However, the benchmark Stoxx 600 index pretty much peaked in May, immediately after Emmanuel Macron’s election victory in France, and it has found hard to make sustained progress since.
Western European stocks peaked in May
Source: Thomson Reuters Datastream
Whether this is the result of fears over a move by the ECB to taper QE or tighten monetary policy, the euro’s appreciation in value, flagging earnings momentum or a combination of all three remains to be seen – but there could be a link between all three.
It may be more than a coincidence that the euro has gained ground over that time, to further illustrate how tricky it could be for Mario Draghi to extricate the ECB from QE without something untoward happening.
Besides ECB policy, investors can also keep an eye on Belgian industrial confidence indicator the Courbe Synthétique, as it has been an uncannily useful guide to the fortunes of the Euro Stoxx 600 index. (Quite why the views of 6,000 Belgian industrialists provides such a keen insight into Europe’s equity market and economic fortunes is a matter for debate).
Bulls of Western Europe may therefore be pleased to see the Courbe Synthétique reach an 18-month high of 0.5 in October, after two consecutive drops down to a reading of -3.5.
Bears will counter by pointing out how the Belgian indicator simply tallies with European stocks’ peak in May and apparent subsequent loss of momentum.
Belgium's Courbe Synthétique is a good indicator for Eurozone equities
Source: National Bank of Belgium, Thomson Reuters Datastream
Russ Mould, AJ Bell Investment Director
Read more from our World Investment Outlook 2018 series:
World Investment Outlook - Chapter one: UK
World Investment Outlook - Chapter two: USA
World Investment Outlook - Chapter three: Japan
World Investment Outlook - Chapter four: Asia
Written by:
Russ Mould
Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.
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