The mood in Europe has done a complete 180 ... and funds are flowing in
‘The question is whether investors are getting ahead of themselves’
At the end of last year, investment strategists could be forgiven for sounding a distinctly cautious note about the outlook for Europe.
Having been caught unawares by Britain’s decision to vote to leave the European Union and Donald Trump’s victory in the US presidential election, fund managers and investors pointed to the escalation in political risk in the euro zone this year, centred around this month’s high-stakes presidential election in France, as sufficient reason to be prudent.
Yet judging by the recent wave of inflows into European equity funds – investors poured US$1.5 billion into the asset class in the week to March 29, the largest weekly inflow in more than a year, according to data provider EPFR – and the slightly stronger performance of euro-zone equities compared with their US peers since the start of this year, it appears that strategists were overly bearish.
The sharp improvement in sentiment (European equity funds suffered a massive US$100 billion in outflows last year, exacerbated by the Brexit vote) stems from growing confidence in the euro-zone economy.
On Wednesday, the publication of a purchasing managers’ index survey by IHS Markit, another data provider, showed the euro-zone services sector was expanding at its fastest clip in nearly six years. This came hot on the heels of another PMI survey published on Monday showing the bloc’s manufacturing sector also enjoyed its best quarter of growth since 2011.
Most encouragingly, the economic upturn in Europe is broad-based.
The manufacturing industry in Italy, the most vulnerable economy in the euro zone due to a toxic combination of excessively high public debt and a chronic lack of growth, is experiencing one of the strongest expansions in the bloc while the services sector of France, the other laggard among the euro zone’s largest economies, is enjoying one of the briskest rates of growth.
The jobless rate, long the scourge of Europe’s single-currency area, has dropped to its lowest level since 2009, with more than one million people lifted out of unemployment over the past year.
Even the political landscape in the euro zone appears to be less treacherous than markets had feared at the beginning of this year.
The worse-than-expected showing of Geert Wilders’ far-right party in the Dutch parliamentary election last month and the strong performance of Emmanuel Macron, the centrist candidate and frontrunner in France’s two-stage presidential election (the first and second rounds take place on April 23 and May 7 respectively), in two television debates are contributing to the improvement in market sentiment towards the euro zone.
Even on political grounds, the case for investing in Europe’s single-currency area is starting to look more compelling, according to many strategists.
The odds of the reform-minded Macron winning the French election and a victory for Martin Schulz, the popular new leader of Germany’s Social Democrat party, in the country’s closely watched parliamentary election in September are increasing. A president Macron and a chancellor Schulz could reinvigorate the Franco-German motor of European integration, helping instil confidence in the euro zone.
Add to this more attractive equity valuations compared with the frothy US stock market and the continuation of the European Central Bank’s aggressive monetary stimulus until at least the end of this year, and it is not surprising that sentiment towards Europe is improving.
The question is whether investors are getting ahead of themselves.
In the near term, two significant risks loom.
The first one is the uncertain outcome of the French election. Although far-right leader Marine Le Pen has a mountain to climb to win the run-off, a dramatically low turnout, coupled with support from some right-wing voters, could hand her victory. While the risk is fairly remote, a Le Pen win would severely undermine sentiment towards French and southern European assets.
The second, and more important, one is Italy.
While Le Pen is very unlikely to be France’s next president, her main populist counterpart in Italy, the Five Star Movement, which has vowed to call a referendum on the euro, has a strong chance of winning a crucial parliamentary election due to be held within the next year. Investors should be more concerned about the risk of an “Italexit” rather than a “Frexit”.
The bulls may be getting louder on Europe, but the bears are still growling, and could yet be vindicated.
Nicholas Spiro is a partner at Lauressa Advisory