European Investment perspectives
Talk is cheap: Much optimism, no conviction (so far)
- Many investors think Europe could surprise positively in 2017. But despite favourable valuation and positive macro momentum, European assets got a disappointing start to the year.
- Should investors put their money where their mouth is? Three “known unknowns” must be considered: Politics, China and banks.
- Avoiding negative political surprises is a precondition for European performance, but banks and China also matter, especially longer term.
In the beginning of the year, investors tend to ask themselves which region could surprise positively in terms of growth and returns. For 2017, equity investors, in particular, point towards Europe. In many respects this optimism seems plausible. Companies’ earnings are being revised upward, growth is close to the pre-crisis trend, running almost neck and neck with the US, and macro numbers are unusually positive in general. At the same time, relative valuation is attractive, at least in terms of equity.
But so far, investors are not putting their money where their proverbial mouth is. European performance has been disappointing year-to-date. While investors are signalling optimism, they lack the conviction to follow through. From a top-down perspective, we see three factors justifying scepticism – some more obvious than others. In our view, in order for optimism to turn into conviction and therefore sustained performance, at least two out of three need to turn in Europe’s favour.
The political wall of worry: Overdone?
Firstly, the political factor dampens investor appetite in Europe. With upcoming elections in the Netherlands, France, Germany and possibly Italy, politics come to the forefront once more. Investors are on their toes – understandably so given the lack of clear answers to the political challenges Europe and the monetary union are facing. European equities might be cheap, but not cheap enough unless political uncertainty goes in reverse (see chart below).
What is causing this uncertainty? Adding to European election jitters are the unknown consequences of the US elections and Brexit. Particularly the latter as it is still unfinished business. The tail-risk worry this might cause is questions about the monetary unions’ cohesiveness after Brexit clearly demonstrated how disjointed the European Union is.
At this point, politicians haven’t been able or willing to address this worry, which adds to the uncertainty. Even the anchor of post-Lehman market stability – the ECB – is sounding less convincing in this context. True, Draghi still insists on the irreversibility of the Euro. That’s his job. But at the same time, he was recently cited for saying that any country leaving the Euro has to settle its bill, contradicting the ECB’s own irreversibility-mantra.
Nevertheless, there is a distinct possibility of a reduction of uncertainty in the course of 2017, so we shouldn’t lose sight of the upside potential amid all the well-flagged political risks. If Europe avoids the empowerment of populist parties, a significant relief rally can be expected, at least in the short term. Highest on investors’ political wall of worry in 2017 is the French election in May/June. On the positive side, the chances of Le Pen winning the second round seem low at the time of this writing. In Germany, the populist anti-EU AfD party is currently losing potential voters to the pro-European candidate Schulz, and the Euro-sceptic 5-star movement in Italy is currently its own worst enemy.
Another important factor could tilt the balance against populist movements in Europe: The role of the political establishment. One of the factors enabling both the Brexit and Trump campaigns was their strong support from parts of the conservative establishment. Trump was backed by a solid segment of the GOP and the UK’s Leave campaign was deeply rooted in the conservative party. This is an important difference relative to much more isolated populists in Euro Area countries. While this isolation doesn’t prevent market-negative election results, it does raise the bar.
Under the radar: The China link
Secondly, China plays a crucial role for the European outlook. A weak Euro and Chinese demand helped lift European growth back to trend levels over the recent quarters via exports. Amid the trade links between the regions, Chinese credit growth has a decent lead relative to e.g. Euro Area exports to China, which in turn has leading properties relative to overall Euro Area exports. Germany, in particular, gained from Chinese spill-overs, having the highest ex-Euro Area export share among the big Euro Area economies (see chart).
But China’s growth pick-up relies on “old sinners”, as it is largely driven by a politically engineered credit boom reflected in a significant acceleration in money growth. If you doubt how big the credit-fuelled recovery in China has been, just look at its sheer size: In the first 10 months of 2016 Chinese infrastructure spending equalled the amount Trump intends to spend on infrastructure over the coming decade (roughly 1 trn USD).
Looking ahead, the key question is: how sustainable is this credit fuelled growth driver? In the grand scheme of things, higher leverage is not what China needs; to the contrary. Fundamentally speaking, mission is accomplished when it comes to fending off the hard-landing fears that dominated in the second half of 2015. Politically speaking, window-dressing growth becomes less important the closer we get to the 19th national congress of the communist party in autumn. In sum, policy makers in China have incentive to take their foot off the credit pedal if they want to avoid raising financial stability concerns.
Signs of this are already emerging. Although the numbers suffer from usual seasonal issues, credit and overall money growth have slowed in recent months. So whereas the downside risks from the political front in Europe are well flagged, the potential negative spill-overs from fading Chinese stimulus could take investors by surprise, unless China manages to placidly phase out the credit boom.
Europe still has a credit issue
Finally, the third factor is about banks and the credit side of the economy. Banks matter, more so in Europe than in the US, as the non-financial sectors dependence on bank financing compared to e.g. the US is significantly higher. Consequently, credit measures tend to be good medium-term growth indicators for the Euro Area. While short-term growth indicators such as PMI’s currently are signalling a booming economy, medium-term credit indicators are less positive. Loan demand is showing signs of weakening (see chart below). Credit flow data are pointing towards 1% annual GDP growth rather than the current run-rate of 1.7%.
Sustained improvement on the credit side is needed for a more self-sustained recovery in Europe. Bank capitalisation has improved, which is undoubtedly positive. But unfortunate links between credit and politics remain, preventing credit growth to take off in earnest. Firstly, demand for credit stays subdued as long as policy uncertainty is high. Secondly, credit supply remains limited as long as banks are not fixed and the bank-sovereign nexus is not broken. The structural flaws of the banking sector are unlikely to disappear as long as a full- fledged banking union is just wishful thinking. Many of the weakest links in the sector have not been closed down or absorbed by stronger banks. On the other hand, progress on the clean-up front would be a major positive, with Italy being the bellwether.
Sell the rumour, buy the fact?
In a nutshell, we expect politics, China and banks to be crucial drivers behind performance of European assets in 2017. In the same vein, they should serve well as signposts for investors looking to increase European exposure.
A realistic case can be made for the Euro Area avoiding worst case political scenarios. In that case, “sell the rumour – buy the fact” obviously would be a tempting investment strategy, i.e. adding to European exposure close to the election dates. But we have to be humble: Firstly, the main lesson to be drawn from last years’ surprises is that analysts’ ability to forecast political events is limited to say the least. Secondly, the forecasting community is equally bad at guessing market reaction – even assuming the political outcome is known. Who would have expected an immediate equity rally after a Trump victory? So avoiding negative political surprises in 2017 is a necessary, albeit not sufficient conditions for a medium term positive view on risk assets in Europe.
In order to make the case for a more sustained European outperformance, at least one of the two other more fundamental factors needs to play in Europe’s favour as well. For investors willing to accept the resulting short-term political uncertainty as well as medium-term fundamental uncertainty, Europe offers attractive return potential. All others might hold their horses for now.
About Nordea Asset Management
Nordea Asset Management (NAM, AuM 217 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 323 bn EUR*). NAM offers European and global investors’ exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.
Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.
Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.
*Source: Nordea Investment Funds, S.A., 31.12.2016
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