Specific Market Reviews – Europe
Good news can’t go on for ever and the momentum of The Great European Recovery Story appears to be stalling. Industrial production, business confidence and retail sales data have all disappointed this year as the euphoria of 2017 begins to dissipate. The weather, industrial action and a flu epidemic have been thrown into the mix as reasons for the slowdown so breath is bated to see if Q1 growth of only 0.4% (down from 0.7% in Q4 2017) was a blip or the beginning of a trend. The Purchasing Managers Index was down again in May and the weakest reading for 18 months so the direction of travel is not promising. Europe has a large export sector and is more highly geared to global growth than the US or UK so a stronger euro and threat of trade tariffs are significant headwinds. The cyclical peak in the rate of growth may have passed but it still leaves the Eurozone in reasonable shape and certainly far better than the doom laden expectations of a couple of years ago.
The slowdown in economic momentum shows yet again what a canny operator Mario Draghi has proved to be at the ECB. Draghi has been very reluctant over the last couple of years to take his foot off the loosening pedal and only now has the ECB decided to scale down its asset purchase QE scheme which is to be finally retired at the end of the year. The omnipresent fear is that as the ECB has been such a huge buyer of European bonds that ending the QE programme may result in a rise in both bond yields and the euro. This could knock the stuffing out of the Eurozone economy and worse, set of a widening of bond spreads in the periphery precipitating another Greece/Italy crisis. Interest rate rises thus remain on the far distant horizon with maybe a mini 15bps hike in September 2019 being the first step.
If Brexit is a headache for the EU then events in Italy must be giving it a heart attack with an unholy coalition of the two populist parties the left-wing Five Star and the far–right Northern League now in government. The political earthquake has woken investors up to the risks of their policies and Italian bond yields initially spiked sharply upwards, which in turn threatens the solvency of the Italian banking system. Italy is not Greece; it has an annual budget surplus before interest payments, an average bond maturity of around seven years and much of the debt is held by domestic investors. The Italians may have converted form Europhiles to Eurosceptic in recent years but even the populists know that Il signore on the Roma autobus does not want to see his savings decimated and job axed by leaving the single currency. With the ECB still hanging in there for the time being as buyer of last resort then the position is manageable for now, but could get dangerously out of hand very quickly, with ‘contagion’ risk into other European bond markets the other shoe to drop.
Summary: The ‘great economic recovery’ story is losing some momentum and events in Italy highlighted the ongoing dysfunctionality of the Eurozone. Nevertheless, strong earnings growth and fairly priced valuations provide support for the equity markets.