European equity markets have had a tough year. The economy has failed to live up to the expectations at the start of the year that European growth would be fuelled by easy financial conditions and falling unemployment.
Regional business confidence surveys have fallen steadily since January. At first this looked like a temporary blip, caused by bad weather. But the weakness has persisted. Investors are now questioning whether the European recovery is altogether faltering.
Looking at the detail of the slowdown, it appears that weakness in net exports explains most of the moderation in growth. The contribution of net exports to annual GDP growth fell from 1.4 per cent in the fourth quarter of 2017 to 0.4 per cent in the second quarter of 2018.
Several factors contributed to this decline. The euro strengthened by nearly 10 per cent from November 2017 through to April 2018, while oil prices increased meaningfully towards $80 (£63) per barrel.
The strength of the euro dampened exports, while higher oil prices have led to rising import costs.
The positive news is that many of these temporary factors have faded, with oil prices coming down from their recent highs and the euro depreciating against the dollar. However, a slowdown in China has also weighed on external demand in Europe.
To answer the question on whether the euro area is capable of regaining its balance or if the current downward momentum has further to go, it is crucial to focus on domestic demand.
So far, domestic demand has remained quite healthy and contributed on average 75 per cent to overall demand since 2010.
The unemployment rate continues to fall at a pace of about 1 percentage point per year, while wage growth has started to pick up. If this trend continues, it should support consumer confidence and consumption.
The European Central Bank is currently on autopilot, with monetary conditions remaining very loose and interest rates not set to rise until at least the end of summer 2019. Healthy credit demand and loan growth to non-financial corporations, and record-low loan costs, remain supportive for investment and ultimately GDP growth in the region.
The biggest concern will likely come in the form of trade tensions and the possibility of a hard Brexit.
These risks could dampen growth in China and Europe, leading to a further slowdown in trade activity.
Additionally, the uncertainty caused by these concerns could hurt the willingness of businesses to commit to new investments.
We have already seen this in part, with weak new order data since the trade dispute between the US and China intensified and the Brexit negotiations stalled. We are more optimistic that there will be a Brexit deal than we are about the prospect of a thawing in trade tensions.
A positive deal on both fronts should help to keep European growth above trend, of around 1.5 per cent year on year, as we move into 2019. This would make current expectations for European corporate earnings growth in 2019 of high single digits look reasonable.
This still wouldn’t place European equities at the top of the worldwide earnings league, because US equities are expected to deliver the fastest earnings growth next year. But the earnings growth differential with the US will likely converge from a 15 percentage point disadvantage to only 2 percentage points in 2019.
Even after the recent underperformance, and with undemanding valuations, there is currently no strong case to go overweight on European equities due to the numerous political risks. But an outlook for relative stable earnings growth and the convergence of growth rates worldwide makes an underweight position in Europe less compelling.
Karen Ward is chief market strategist for EMEA at JPMorgan Asset Management