Quarterly Perspective: European recovery – headwinds become tailwinds


The good news from the eurozone has continued in 2015, with the economic recovery gaining ground in the summer—despite worries over Greece and China—and peripheral economies such as Spain making particular progress. But global volatility has hit European equities, leaving them looking reasonably valued on traditional metrics, although still not cheap. We believe that continued growth in corporate earnings, coupled with still highly supportive monetary policy, provides plenty of upside potential for asset prices, particularly in domestically oriented sectors that can now finally benefit from the recovery. The headwinds of a strong euro and higher borrowing costs that have hindered Europe over the last few years have reversed, becoming supportive tailwinds with the falls in the euro and in borrowing costs.

Credit growth has been the biggest positive surprise

As borrowing costs have come down, demand for lending has picked up. This is important because, historically, credit demand has been a strong leading indicator for growth in GDP, as seen in the chart below. This makes sense as the majority of money that is borrowed is spent. Rising demand for credit suggests that borrowers have more confidence in the recovery. But the upturn in loan demand has so far been driven largely by households. Going forward we would hope to see more borrowing by companies to fund investment, which continues to lag. But with most companies still operating with spare capacity, it is no surprise to see them biding their time.

Improving loan demand is key for European growth and avoiding deflation.


It’s not just the cheaper euro – and it’s not just the core economies

In recent years, eurozone growth was driven mainly by the core economies—notably Germany—and by net exports. Domestic demand was weak and peripheral economies such as Italy and Spain continued to struggle. But domestic demand has grown faster than exports so far in 2015, and business surveys show that the peripheral economies are now performing better than those in the core. The commitment of some countries in the periphery to reforms, together with the improvement in economic sentiment, which is helping to unlock significant pent-up demand, has helped to draw investor attention to peripheral asset markets. One example is Italy’s stock market, which has outperformed other eurozone markets since the start of the year.

Emerging market and Greece concerns overdone

Recently, investors have begun to worry that emerging market (EM) weakness would hurt European exports. However, domestic demand is far more significant for eurozone GDP. For example, German domestic demand is more than 35 times larger than German exports to China.

A more significant EM slowdown would have some negative impact on Europe. But we would expect the European Central Bank (ECB) to offset any genuine tightening in global conditions by expanding or strengthening its quantitative easing programme, further weakening the euro and supporting eurozone equities. Conversely, if the EM growth outlook improves then equities should perform well too, as it was EM concerns, along with worries about Greece leaving the euro, that led to the summer sell-off.

Greece could still eventually leave the euro. The stand-off between Greece and its creditors has generated a fair amount of ill will on both sides. But with the anti-euro element of Syriza no longer in government and Alexis Tsipras having now committed to doing what it takes to keep Greece in the single currency, we do not believe that Greece’s problems will pose a risk to European stability in the near term.

Eurozone GDP is no longer reliant on exports as domestic demand recovers.


Margins and earnings to improve

With the improving economy, corporate earnings in the eurozone are now also improving, after years of disappointments. European earnings excluding the energy sector grew by close to 20% year on year in the second quarter. We think earnings can continue to grow, because growth in the broader economy suggests not only higher sales but also higher margins, which have lagged behind the US in recent years. The weak euro, cheaper commodity costs and lower interest rates should all gradually feed through into higher profits as currency and commodity hedges roll off and companies refinance. The lags involved in this process suggest to us that the benefits of lower commodity prices, cheaper borrowing costs and the weaker euro are yet to be fully reflected in reported earnings. Further declines from here would provide an additional boost to earnings, but are not required for continued earnings growth.

European margins have room to recover relative to the US and history.


Investment Implications

  • The summer sell-off has left European equities looking relatively attractive, as earnings have increased and can grow further, while stock prices have declined.
  • The ECB is willing to print even more money, if necessary, providing some downside protection in the event that emerging market turbulence hits European markets further. For UK- and US-based investors, a hedged strategy is worth considering, given the likely currency implications of further ECB easing.
  • Domestically oriented sectors and companies have outperformed during the summer sell-offs and still look undervalued relative to exportoriented sectors, despite showing generally stronger earnings growth in recent months. This underscores the importance of an active approach, investing in assets that are poised to benefit from a longawaited domestic recovery.

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