Are investors wrong to be so bullish on Europe?
‘The good news is that the European Central Bank appears to be in no rush to tighten monetary policy, particularly given subdued inflation levels in the euro zone’
Last summer, the prospect of Emmanuel Macron and Donald Trump presiding over the annual Bastille Day celebrations in Paris as presidents of France and the US respectively was almost unthinkable.
Yet on Friday, it was the former Rothschild banker and the New York property developer who celebrated the 100th anniversary of America’s entry into the first world war in a sign of the extent to which the political landscape in the leading Western democracies has changed over the past year.
The contrast between the policy agendas of Macron and Trump – the French president is a passionate believer in European integration, defends free trade and wants to liberalise France’s economy, while the reality-television star is a populist-nationalist who opposes globalisation and applauded Britain’s decision to leave the European Union – could not be starker and, in the minds of international investors, is a major factor behind the growing appeal of Europe.
In the most unexpected development in financial markets this year, it is the euro zone that has been ticking the right boxes.
Political risk, which was weighing on sentiment towards Europe at the start of this year because of fears that far-right leader Marine Le Pen might win the French presidency, is now more prevalent in the United States as evidence mounts that Trump’s family colluded with Russia during last year’s presidential election campaign, severely undermining Trump’s authority and policy agenda and fuelling speculation about his possible impeachment.
On Friday, Jamie Dimon, the head of JPMorgan Chase, said: “It’s [now] almost an embarrassment being an American travelling around the world”.
The euro zone’s economic recovery, moreover, is going from strength to strength. In the second quarter of this year, Europe’s single-currency area enjoyed its strongest period of expansion in six years, with all the manufacturing and services sectors in the 19-member bloc enjoying growth for the first time since April 2014, according to IHS Markit. Even France and Italy – the euro zone’s second- and third-largest economies respectively, which face the greatest structural challenges due to long-standing resistance to much-needed labour and product market reforms – reported faster growth in the second quarter.
Unemployment, the scourge of the euro zone’s economy ever since the 2008 global financial crisis erupted, has fallen from more than 12 per cent four years ago to just over 9 per cent, while credit conditions – a much more important gauge of growth than in the US due to the heavy reliance of Europe’s legion of small and mid-sized firms on bank lending – have eased significantly over the past two years.
European stocks are also more attractively priced, fuelling this year’s surge in inflows into the region’s equity funds. According to JPMorgan Asset Management, while the price-earnings ratio of US equities – which many investment strategists believe are in, or are fast approaching, bubble territory – is close to 18, its European equivalent is slightly over 15.
Indeed, according to last month’s global fund manager survey published by Bank of America Merrill Lynch, while nearly 45 per cent of respondents believe global equities are now overvalued – the highest proportion since the survey began in 1998 – nearly one-fifth believe that European shares remain undervalued.
More tellingly, while a break-up of the euro zone was still cited as the biggest concern of money managers as recently as April (prior to Macron’s victory in France’s presidential election), a tightening in Chinese credit conditions is now considered to be the biggest “tail risk” confronting the global economy, according to the survey.
Make no mistake, Europe is flavour of the month with international investors.
The question is whether sentiment has become too bullish.
The biggest risk facing the euro zone is the withdrawal of monetary stimulus by the European Central Bank, the very same factor which, five years ago this month, averted a possible dissolution of Europe’s fragile monetary union.
As the recent surge in government bond yields attests, investors are acutely sensitive to any signs that quantitative easing will be scaled back prematurely or too quickly, putting significant strain on Italy’s debt market – the most likely source of financial stress, given the country’s huge debt burden, vulnerable banking sector and volatile political climate.
The good news is that the European Central Bank appears to be in no rush to tighten monetary policy, particularly given subdued inflation levels in the euro zone. The bad news is that unwinding five years of ultra-loose monetary policy is unlikely to be a smooth process and could easily trigger a major sell-off.
For investors in Europe, it is not going to be plain sailing.
Nicholas Spiro is a partner at Lauressa Advisory