Investors beware: Eurozone not half as resilient as financial markets suggest
The past few weeks have not been kind to Europe’s single currency area
On September 24, German chancellor Angela Merkel, long seen as a pillar of stability in a world shaken by Britain’s exit from the European Union and the election of Donald Trump as US president, suffered a stinging rebuke when the far-right Alternative for Germany (AfD) party took a million votes from her conservative bloc to win 13 per cent of the vote in the country’s parliamentary election.
While Merkel secured a fourth term as chancellor, recriminations over her party’s extremely poor performance will make it difficult to form an unprecedented three-way coalition government and will force Merkel to take a harder line on financial support to shore up the euro zone.
As if this were not troubling enough, Spain, Europe’s fourth-largest economy, is on the verge of a full-blown political and constitutional crisis after 90m per cent of nearly 2.3m voters in Catalonia (one of the country’s richest regions whose economy is the size of Portugal) voted on Sunday to secede from Spain.
While the referendum was illegal under Spanish law, shocking scenes of violence on the streets threaten to undermine Spain’s already shaky minority government and have unnerved international investors.
On Wednesday, Spanish stocks (in particular Catalan banks) and bonds came under renewed strain after suffering losses earlier in the week. Two of the world’s largest credit rating agencies have warned that the escalation in tensions between Madrid and Barcelona could dampen growth in Spain and the rest of the euro zone.
Yet one need only look at the response of European equity markets to realise the extent to which sentiment towards the euro zone as a whole remains bullish.
While Spanish shares have fallen, the Stoxx Europe 600, Europe’s leading stock market index, even rose slightly in the first-half of this week, having risen more than 6 per cent since the end of August to just shy of its highest level this year.
In a fund manager survey published by Bank of America Merrill Lynch last month, a “long”, or overweight, position in euro zone stocks was cited as one of the most popular trades, with investors’ allocation to euro zone equities having risen significantly above its long-term average level.
The day after the Catalan referendum, the publication of a buying Managers’ Index (PMI) survey revealed that the euro zone’s manufacturing sector last month expanded at its fastest pace in more than six-and-a-half years. Even more impressively, a measure of employment in the sector grew at its briskest pace since the survey began in 1997.
IHS Markit, the publisher of the survey, notes that the euro zone is enjoying “a manufacturing boom”, with the recent appreciation of the euro – the single currency has gained nearly 10 per cent against the dollar since mid-April – “barely dent[ING] export growth” while domestic demand has improved.
While the euro itself weakened slightly against the dollar on Monday, it was already rising again by Tuesday morning.
Yet investors would be well advised to be cautious. Europe’s 19-member single currency area is not half as resilient as market indicators suggest.
The five-year-long period of financial stability in Europe has its roots in the ultra-loose monetary policies of the European Central Bank and Germany’s willingness to provide the lion’s share of financial aid to countries that required rescue programmes, such as Portugal and Spain.
Both of these underpinnings are giving way.
The ECB is preparing to scale back, or “taper”, its asset buys which still amount to €€60 billion a month and have been instrumental in pushing down bond yields and buoying sentiment towards the euro zone.
The unwinding of quantitative easing (QE), which is expected to be formally announced at the ECB’s next policy meeting on October 26, will remove the main source of support for European asset prices, particularly in the vulnerable economies of southern Europe.
Make no mistake, a post-QE euro zone will make for a much more volatile financial landscape.
Just as importantly, Germany, Europe’s chief paymaster, is likely to become even more reluctant to come to the rescue of weaker euro zone economies following last month’s election.
Merkel’s personal standing – both domestically and on the European stage – has been weakened significantly, constraining her ability to provide the necessary financial support to shore up Europe’s shaky monetary union.
But the country to watch is Italy. Not only is Europe’s third largest economy the weakest link in the euro zone – Italy suffers from excessively high levels of public debt, strong support for populist parties and vulnerable banks – it has the most to lose from the end of QE.
Investors should enjoy the rally in euro zone assets while it lasts.
Nicholas Spiro is a partner at Lauressa Advisory