While investors have taken an increasingly dim view of Europe and its stock markets there might be some glimmers of hope for those with a longer-term outlook, according to JP Morgan Asset Management’s Tilmann Galler.
Galler, global market strategist at JP Morgan Asset Management, noted that after a strong showing in 2017, the European economy has disappointed since the start of 2018.
“Certainly, there was a lot of promise and expectation for European growth at the start of 2018.” said the strategist.
“Fuelled by easy financial conditions and falling unemployment, the European recovery looked to be finally finding its feet. Since then, economic data for the region has deteriorated.”
Source: IMF
Having grown by 2.4 per cent in 2017, according to data from the International Monetary Fund’s World Economic Outlook, economic expansion in the eurozone slowed to 1.8 per cent last year and the outlook remains modest.
JP Morgan’s Galler said a number of factors have contributed to slowing growth over the past year, but investors have begun to lose patience with the region.
He added: “With few domestic catalysts for a turnaround, it may take a rebound in demand from the emerging world to improve prospects for the region.”
Weaker exports last year combined with a sharp increase in imports as oil prices rose, leading to a trade deficit.
“Given that exports make up approximately half of GDP in the eurozone, a slowdown in global growth was always going to prove a strong headwind,” the strategist said. “In particular, demand from emerging markets has softened.”
Emerging market demand has fallen away as US president Donald Trump has taken a tougher stance on trade; this was compounded by a slowdown in Chinese economic growth.
Galler said domestic factors had also had a significant role to play in slowing European growth, most notably the Italy-EU budget dispute and the French ‘gilets jaunes’ protests. Additionally, European Parliament elections to be held in May could show that populist parties continue to command significant support.
Despite the challenges, there are still some potential catalysts that could spark growth in European markets, according to the JP Morgan strategist, who highlighted the falling unemployment rate and rising wages across the bloc.
In addition, oil prices have dropped significantly since peaking in October last year, which – along with wage growth and falling unemployment – is also supportive of consumer spending.
As the below chart shows, the Bloomberg Brent Crude Sub index rose by 41.4 per cent in euro terms by early October, before ending the year down by 10.6 per cent. Galler said the falling oil price has acted as a “significant tax cut for European households”.
Performance of index in 2018
Source: FE Analytics
He added: “Historically, there has been a close inverse relationship between the oil price and consumption in the region, suggesting that the recent move in oil can help to boost consumption, and may also help European businesses by easing cost pressures.”
Monetary policy is also likely to remain accommodative as European Central Bank president Mario Draghi steps down towards the end of the year. Accommodative policy, said the JP Morgan strategist, will keep lending rates at a supportive level.
And with growth in the eurozone economy forecast to remain subdued in the coming years, the central bank has begun to consider what can be done to provide further stimulus, such as the renewal of measures to incentivise banks to lend to non-financial corporate companies and households.
However, there are limits to what the ECB may be able to do to further stimulate the economy, particularly with key interest rates already in negative territory and with its scope for further quantitative easing constrained.
“On the fiscal side, governments are moving to incrementally looser policies – notably in Italy and France,” added Galler. “But these countries will ultimately be constrained by their already high public debt-to-GDP ratios.”
As such, the eurozone economy may have to rely on an improvement in external factors to provide the key stimulus for a turnaround in sentiment among manufacturers and consumers. Such factors might include the avoidance of a hard Brexit, de-escalation in trade tensions or a soft landing for the Chinese economy.
While the economic outlook for the eurozone may remain challenged, negative sentiment towards the region may have created some interesting valuation opportunities in the listed European markets.
“The multitude of elements that have contributed to a slowdown in Europe, coupled with the absence of a clear catalyst for a turnaround, has left investors cautious of investing in the region,” the strategist explained.
“But it is worth remembering that approximately 50 per cent of European corporate revenues come from outside the region.”
He added: “In 2018, the European macroeconomic environment continued to deteriorate, but companies were still able to achieve a respectable 5 per cent earnings growth.”
Yet, as last year showed, there are reasons why investors would have been right to remain cautious.
The MSCI Europe ex UK index was down by 9.87 per cent last year and the average IA Europe Excluding UK fund performed even worse making a 12.16 per cent loss, in sterling terms.
Performance of sector vs index in 2018
Source: FE Analytics
As a result, European equity strategies have so far this year have seen outflows of £450m after redemptions of £1.3bn last year, data from the Investment Association shows.
A longer-term view of the region may be rewarded, said the JP Morgan strategist, although it may take some time for attitudes to change.
“An uncertain economic outlook for the region suggests investors should remain cautious in the near term,” said Galler. “But the international nature of European companies and the broader eurozone economy means that the direction of the global growth environment will have a large bearing on future performance.”
He concluded: “Investors will likely stay on the sidelines in Europe until we get the promise of a lasting recovery in growth.”