Readers, welcome to my new regular column, Short and Sharp. It will be fortnightly articles, focused on current market discussion topics, taking a strong point of view and without using a lot of ink – short and sharp.
Investors have shunned European assets at their peril. European equity markets have gained around 10% so far this year, outperforming the U.S. equity market. And now, with the French presidential election having passed uneventfully, investors should re-focus on the Eurozone’s improving growth prospects and relatively attractive valuations. European stocks have room to run.
Investors have, so far, overestimated European political risk. In the Dutch election in April, the anti-European Union (EU), anti-establishment Freedom Party failed to come in first place. And in the French presidential elections this weekend, centrist candidate Emmanuel Macron won a wider victory over the far-right anti-EU candidate, Marine Le Pen, than polls had projected. The threat of “Frexit” has been consigned to the bin… (to be recycled in five years’ time).
Interestingly, in the second round, Le Pen gained more voters who identified themselves as being on the “far-left” than those who identified as merely “left.” This highlights the growing trend in politics: it is no longer a battle between the traditional left and right factions of politics, but between the establishment and populism.
The next two elections in the European calendar should pose minimal concern for investors. The UK will go to the polls in June, most likely delivering a thumping victory for the Conservatives. In Germany, the race is closer but neither of the two key candidates, Merkel and Schulz, are likely to disrupt markets. Meanwhile, the date of the Italian election is still an unknown and could certainly create some severe bumps on the road. But that is a story for after the summer…
Right now, investors should be thinking about the European growth story. The Eurozone has consistently beaten growth expectations over the past quarters. Activity surveys point to strengthening economic momentum and inflation is rising in several countries, including Germany and the Netherlands. The European Central Bank (ECB) acknowledged these developments at its latest meeting and, with the fading of political risk, could be set for a change in tone.
I expect the downward interest rate bias in the ECB’s forward guidance to be removed at its next meeting in June. It may then announce, at its September meeting, a plan to wind down quantitative easing (QE) starting in early 2018. But the difference between the Federal Reserve and the ECB will still be palpable. While the Federal Reserve balance sheet may start shrinking in 2018 (by ceasing or phasing out reinvestments), the ECB balance sheet will still be growing, just at a slower pace.
What does that mean for investors? In European credit, a change in the ECB’s tone should steepen the yield curve, boosting financials. What’s more, as ECB corporate QE has only included non-financials, the coming unwind of QE should benefit financials relative to non-financials.
And in European equities, the story is even more positive. Strengthening European growth, easy ECB monetary policy compared to the Fed, robust earnings estimates, abating political risks and (relatively) attractive valuations all add up to European equities continuing to outperform U.S. equities. Vive l’Europe!
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