Why the fate of European stocks lies with China
Fiscal rules and still-loose monetary policy mean the region has to look elsewhere for stimulus
We are a long way from Mario Draghi’s “whatever it takes” reassurances for the eurozone. While the fury of the region’s debt crisis has passed, the eurozone is beset by slowing growth prospects, Italy’s budget fight with Brussels and wounded leaders at the helm of Germany and France. Hardly helping matters is Albion, with Brexit and the risk of a badly managed UK exit in March, or perhaps even a no deal.
This week marked the end of an era in monetary policy as the European Central Bank formally halted its €2.6tn bond-buying programme. While a historic moment, the fact that the ECB also tempered its outlook for growth and inflation for 2019 should be of greater interest to investors.
Almost four years have passed since the ECB announced its plan for quantitative easing in early 2015 and, when you look at where the economy and markets are today, the unavoidable question is what has really changed?
The bottom line is that inflation is falling, and signs of a sustainable recovery remain elusive. With Europe restricted by budget rules and interest rates still negative, there is little wriggle room should the economy weaken from here.
Less an engine of the global economy, Europe and its exporters rely on foreign demand to help offset poor demographics. At the same time, it continues to struggle with a one size fits all monetary policy.
A meaningful ceasefire in US-Sino trade tensions will undoubtedly register for Europe, as would any sign of China’s economy picking up speed. Both are possible outcomes in 2019, but neither can be relied on. Alleviating some of the region’s economic pain this year has been a weaker euro, but once the Federal Reserve pauses monetary tightening and focus switches to the rising US budget deficit, plenty believe that trend of euro weakness will be on borrowed time.
The importance of a weaker single currency is clear looking at corporate earnings expectations for next year. CFRA note that analysts still see earnings growth rising for the S&P Euro 350 to 8.5 per cent in 2019 from 7.1 per cent in 2018, thanks mainly to a weaker euro boosting the value of revenues generated outside Europe. This rosy outlook is one that the market clearly disagrees with given the index currently trades at a 6 per cent discount to its long-term average price-to-earnings ratio.
“As the economic environment continues to slow, earnings growth will be at risk,’’ Lindsey Bell at CFRA cautions. “Political uncertainty and a lack of structural reform for countries such as Italy and France will probably continue to fuel weakness across the euro zone.’’
Indeed, France’s 10-year bond yield this week rose to its highest level over the German Bund since May 2017, as president Emmanuel Macron announced a U-turn on fuel taxes and new spending measures that are estimated to push the country’s budget deficit beyond the EU cap of 3 per cent of GDP next year.
For those mining for value, European shares hold some surface appeal. But they are cheap for a very good reason. As this year has shown, Europe is vulnerable to a protracted trade war, weakening global growth and, as we enter 2019, any signs that confirm the US economy is slowing.
One important component of eurozone equities is financials. With a drop of 25 per cent, it is competing with carmakers as this year’s worst performing group in the Stoxx 600. But if you are looking for a sign of a sustainable bounce in equities, financials need to reverse course. This is an important leadership group for many equity markets, particularly in Europe. While eurozone banks certainly look cheap in price to book terms, they really need a level of economic growth that prompts the ECB to raise interest rates. The bond market, however, has been leaning towards no tightening of ECB rate policy until 2020.
Unless we see financials turn round soon, the broader market will stay under pressure and mired in correction territory.
In the case of Germany’s Dax, it already sits in a bear market for 2018, after a drop of more than a fifth since it peaked in January. The 10-year German Bund yield has loitered around 0.25 per cent, its lowest level since the summer of 2017, as the eurozone’s most important economy suffers from China’s focus on excessive leverage and trade protectionism.
With the ECB’s having already fired its monetary bullets, the answer for the region is a combination of fiscal stimulus and economic reforms, which in France now appear to be on borrowed time. Alas, a fractured EU means there is little hope of greater leeway on spending as Germany demands fiscal discipline.
Ethan Harris at Bank of America Merrill Lynch says there is one bright aspect: “China seems ready, willing and able to reverse its growth slowdown with a steady diet of stimulus.’’
That leaves the case for buying European equities dependent upon the news cycle and decisions made in Beijing, Washington and London.