26th April 2019
Europe: I Want to Believe
Chris Bailey, European Strategist, Raymond James Investment Services
When thinking about international investment in recent months, emerging markets have stolen the spotlight as of late. In short, their scope for population growth and urbanisation provide them the most potential to “catch up” to their wealthier, developed counterparts. By contrast, Continental Europe (‘Europe’) and Japan have been seen as the less attractive cousins.
Europe: A hard sell
The case for investing in Europe is difficult to make at face value. Growth over the past decade has been substantially lower than in the United States or in the United Kingdom. Supranational organisations, such as the International Monetary Fund (IMF), have recently reduced their forecasts for European economic growth. Official interest rates remain negative, per policy that was put in place following the euro crisis of 2013. Given the anaemic growth that has gripped the continent, central bankers have been loath to raise them. Additionally, Europe’s much-vaunted political stability has been challenged by a rising tide of populism, most notably in Italy. Unsurprisingly, equity valuations, investor confidence, and general levels of dynamism all remain noticeably lower relative to North American markets.
However, Europe is not out for the count. It bears mentioning that Europe still matters, despite its current difficulties. The European Union’s 28 member countries still account for 21.8% of global GDP, just behind the United States (24.6%) and ahead of China (14.8%)1. Its currency, the euro, accounts for 34% of global transactions, second only to the U.S. dollar (45%)2. Given that – even if the UK is excluded – it also holds three G7 seats and four G20 seats, Europe still carries significant diplomatic clout.
Quantitative Easing: Only tapping the brakes
The key question for global investors is whether Europe is stuck in an insurmountable malaise, making its financial markets largely unattractive to external investors. In answering this question, investors might look to certain shifts in monetary policy by the European Central Bank (ECB). At the end of last year, the ECB stepped away from undertaking new quantitative easing (QE). This would seem to indicate an awareness that constant monetary stimulus is not necessarily desirable (as shown in the case of Japan, which has maintained stimulative monetary policy for decades). However, this does not mean that the ECB is done with alternative instruments. The ECB announced new targeted longer term refinancing operations (TLTROs) in early March, offering long-term loans to banks that incentivise them to increase their lending to local businesses and consumers. Currently an ability to still undertake stimulus is a net positive. However on its own it is not enough.
Challenges and Opportunities
The biggest impact on much of northern Europe’s economic growth rates in 2019 rests on broader concerns. A pragmatic Brexit outcome would be a boost for all regional countries given the high levels of trade between the European Union and the UK. Ultimately, I consider this a likely outcome. The other exogenous issue (specifically for northern European countries such as Germany, Holland and Scandinavia) is avoiding a broader global trade war (as has threatened to bubble over between the U.S. and China). Progress to date in bilateral trade discussions between China and the U.S. have helped buoy global markets, including those across Europe. Part of the reason is that a material part of the region’s growth (especially in northern Europe) has come from exports, specifically to the emerging markets (especially China) and the United States. These exports have been boosted by the relatively cheap value of the euro over recent years. However, this also indicates that Europe can be an attractive supplier of a broad range of goods and services for the global market, a view which is at odds with the pessimism surrounding Europe’s potential for innovation and productivity.
Avoiding trade tensions is therefore crucial for the immediate outlook for the European economy. Whilst the political leadership of both the European Union and the United States have clashed more regularly in recent years, the United States-Mexico-Canada Agreement (USMCA), and ongoing bilateral China/United States trade discussions indicate that pragmatic outcomes are possible. In short, it would appear the bark of negotiating politicians is worse than their bite.
Even though outcomes surrounding the ECB, Brexit, and external trade factors appear to offer more opportunity than threat, the average investor remains heavily underweight towards Europe. As such, investors are seemingly also concerned about the status of the European political backdrop, as it appears cursed by the confluence of populism and debt.
Populism: Not so popular
If you had to pick the most important date in the European political calendar for 2019, it actually would not be the finale of the Brexit process – it would be the European Parliamentary elections that are due to be held between 23 and 26 May. It is highly likely that in these elections so-called populist parties will make significant gains, though they will still be short of a pan-European majority (in contrast to more centrist, incumbent political parties). Most populist parties inevitably focus on more local and national issues (as seen in recent months in Italy), meaning pan-European coordination between populist parties is likely to remain low. However, the collective threat is real, as it has the potential to undermine efforts to forge pan-European legislation.
This would appear to spell disaster for the EU. How can Europe get more competitive or dynamic if its ability to pass pan-European legislation is being challenged by a greater focus on more populist concerns? And this can be doubly dangerous if a country – as infamously is the case in Italy – has material debt levels that encourage economic sclerosis and credit downgrades. This could, in certain circumstances, increase pressure to leave the European Union. The better news for Europe is that in today’s financially-interrelated world, policies launched by populist parties that do obtain power in specific countries struggle to get traction. We have seen historically in Greece and more recently in Italy (which had to give in to demands to curtail its ballooning fiscal deficit), bond markets are often remarkably effective in battering governments into submission. It is always easier to talk than govern.
And a populist approach focusing on local and national issues that resonate with voters is possibly not all bad. As seen recently in France, Germany and the UK, incumbent governments might very well adopt initiatives to quell such populist concerns. In this sense, Italy will be a fascinating political experiment in 2019. We will see how an instinctively populist government fuses their policy platforms with a need to remain fiscally prudent and market friendly. With current low expectations there could be surprises. If so, this would change European politics for the better.
Given the past decade’s poor economic growth, a bit of change can at least offer some different opportunities. So do not be too worried about the populists. Their rising popularity may just be the nudge that more conventional politicians need to really step up and inspire.
2019: It’s all about belief
Europe’s biggest issue in 2019 is belief. Investors struggle to see a way through. The perception remains that both the ECB and incumbent governments are out of ideas. However, dig a little below the surface and Europe is not without hope. Mix in a pragmatic Brexit deal, avoiding trade tensions, new TLTROs, addressing some of the populists’ more pressing concerns, and a bit more fiscal spending, there just might be a recipe for success. Given the general levels of global investor pessimism and lower than-average valuations, Europe may prove to have more potential than we think.
Drawing it all together, I think Teddy Roosevelt’s quote puts it rather well concerning the outlook for European financial markets in 2019. For investors and regional economic actors alike, it is all about belief.
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