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European delight?

06 September 2019

5 minute read

By Julien Lafargue, CFA, Head of Equity Strategy, Jai Lakhani, Investment Strategist and Maria Vittoria Malavolta, Investment Analyst

As political uncertainty rages across Europe, trade tensions escalate and growth stutters, the outlook for continent looks bleak. However, is the bull-case for European assets as far away as many think?

The slow-down in global growth being experienced in the current late-cycle environment, coupled with escalating protectionism all over the globe, has weighed on Europe in particular. To make things worse, the region has its own geopolitical issues and an ageing population which are a drag on growth.

Despite all the negatives, we believe a bull case for Europe exists. But in order to get there, we need to see several key pieces fall into place. Below we analyse each piece in turn.

More accommodative monetary policy

First, the European Central Bank (ECB) needs to ease. The ECB has turned increasingly dovish in 2019 due to sluggish domestic growth, pulled down by external headwinds such as escalating trade tensions. In addition, subdued inflation, the ECB’s unique mandate, remains well below the “just below 2%” target rate, despite historically low interest rates.

Given the above backdrop, we expect the central bank will implement more easing measures later this month. To be successful, we believe this new round of liquidity injection needs to account for the effect on the banking sector’s profitability (for instance, through a tiered reserve system for banks). Very low rates have pressured this key sector of the economy for too long.

Eurozone stocks soared chart

Reduced trade tensions and more fiscal spending

Second, because the eurozone is heavily exposed to international trade, some softening in trade tensions is needed between the US and its trading partners. However, this may not be enough on its own.

To revive domestic growth significantly, we believe European governments may need to actively step up their fiscal spending. Germany has continued to be particularly reluctant to provide fiscal stimulus. Meanwhile, the need for such stimulus has never been stronger, given that the bloc’s largest economy is now experiencing a significant slowdown.

Currency support needed

Because Europe is an open economy, it needs trade to flow and to remain competitive. As such, a bull case for Europe would require the euro to weaken, or at least not to appreciate much. This seems likely if the ECB acts decisively and injects more liquidity. Ironically, a weaker currency may anger some trading partners, especially the US, potentially ratcheting up trade tensions.

Quiet political landscape

Finally, Europe’s bull case rests on a stable political landscape. This equilibrium is currently threatened by jitters around Brexit and Italy.

The UK’s planned departure from the European Union (EU) is still a big question mark, creating political upheaval for over three years. At this stage all options remain on the table. July’s election of Boris Johnson as prime minister makes a no-deal Brexit significantly more likely, although opposition parties are trying their best to prevent this. A general election could delay, or even stop Brexit altogether. However, the final outcome is still highly uncertain as the 31 October deadline approaches.

Political drama in Italy continues to unfold, with League leader Matteo Salvini having failed for now in his quest for power. The new coalition between the Five Star Movement and the Partito Democratico may provide some temporary stability and boost investor sentiment, supporting the bull case for Europe. However, we would not be surprised to see political risk resurfacing in the medium term.

Hope for bull case Europe

While it is difficult to envisage a scenario where all the above stars align, in our opinion, the bull case for Europe is more likely now than it’s been in for a long time. In some ways, the state of play reminds us of the period before the “whatever it takes” pledge to save the euro from ECB president Mario Draghi in 2012. His pledge resulted in European equities outperforming their global peers for the next five years.

For the time being we remain cautious on Europe, but suggest not foregoing the area’s assets altogether. Even in the current context, the region still offers opportunities, in particular in high quality stocks. Although lower quality, value shares may outperform, should the bull case materialise we believe that, over the medium term, quality companies will continue to deliver better returns.

The bull case for Europe is more likely now than it’s been in for a long time.

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Market Perspectives September 2019

Find out our latest key investment themes. Expectations of more dovish central bank policy could do nothing to prevent a sharp, negative, swing in senitiment in August as recession fears returned to markets. Furthermore, US-China trade tensions seem unlikely to be resolved soon.

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