Investment Strategy:  Fourth Quarter 2019 – Specific Market Reviews: Europe

  • Growth in the Eurozone slowed to 0.2% in the second quarter of the year with a y/y growth rate of 1.1% or ‘very slow cruising speed’ as one economist put it. Ironically, the domestic economies are relatively healthy but with Europe so leveraged to global trade it is the big fall in external demand resulting from the trade wars that is the main culprit. Our base case remains a slowdown to a shallow rather than deep recession.
  • The greatest fears concern the big daddy of the EU, Germany, where Q2 GDP contracted by -0.1% compared to Q1 amidst a perfect storm of negative factors. Exports are 47% of GDP with the economy weighted to ‘old industry’ autos, chemicals and industrial machinery, much of which is exported to China whilst the threat of a no-deal Brexit also hangs heavily on this side of the Channel as well. The massive auto industry in particular is struggling, badly hit by having to adapt to new emissions testing procedures. Germany is close to full employment and wage growth is good so the man on the Unter den Linden Omnibus is feeling pretty smug, but industrial production saw its biggest fall in nearly a decade this summer and the economy is probably already in recession. With a large budget surplus and negative interest rates the obvious answer is shed loads of fiscal stimulus but that just isn’t the way they do things in Germany, the purse strings being held with Teutonic parsimony.
  • In pretty much his last act as head honcho of the ECB Mario Draghi rolled out the monetary guns again, cutting the overnight lending to rate by 10bps to -0.5% and recommencing the QE asset purchase scheme from November. Our sense is that the ability of monetary policy to stimulate the Eurozone economy is exhausted. More importantly (he is after all somewhat more influential than me) so too does Mario himself, hence his pointed remarks to Eurozone governments about the need for a much more expansive fiscal policy and structural reform. So the ball is in the court of the Eurozone politicians, how re-assuring!
  • Banks continue to be a worry in Europe and their share prices continue to be underperformers. Negative interest rates are killing their profits whilst their balance sheets, unlike their US counterparts, have never recovered for the financial crisis. Several Banks have had big lay-offs this year and the danger is that in order to improve solvency they will restrict lending just as the economy slides into recession, creating a spiral of ever slowing growth.
  • Despite the deteriorating fundaments European markets have joined in the global equity party this year with most bourses producing a double digit return for the year. The MSCI Europe is now trading on a forward P/E of around 13.5x which feels pretty much like fair value.

Summary: Equity markets have produced strong returns this year but fundamentals remain challenging as growth flirts with recession and earnings estimates falter. Politics remain as dysfunctional as ever with Brexit a huge problem for the Eurozone, not just the UK.

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