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In my view:
- Strong euro-area equity performance in 2019 probably reflects reduced tail risks, rather than optimism on company growth or earnings.
- Potential upside risk from stronger earnings, healthier GDP growth or rising long-term interest rates could support euro-area assets versus the US.
- Downside risk related to Brexit and potential trade conflicts with the US persists.
- Euro-area equities remain attractively valued, with the possibility of a stronger-than-expected economic recovery.
Have downside risks diminished?
In 2019, euro-area equities very nearly kept pace with the US market, despite an industrial recession, weak economic growth overall in the eurozone, a sharp decline in earnings and rising long-term interest rates.
The market appears to have decided that downside risks have diminished:
- A large-scale global trade conflict that could hurt the euro area now seems less likely.
- A hard Brexit outcome has been avoided (for now).
- Growth in the euro area may be low, but in my view, a sharp recession seems improbable, particularly if global growth picks up.
- Low inflation does not seem likely to turn into deflation.
It looks like markets are pricing in an only modest recovery in growth and earnings, with none of these large downside risks materialising.
Balance of risks is to the upside
Nominal euro-area GDP growth and earnings might recover faster than currently anticipated. The market consensus is for tepid growth, but the trade and investment cycle might turn up more aggressively and faster than expected. Indeed, recent activity indicators are consistent with such a turn. The economic surprise indices suggest a sharp turn in January 2020.
If growth and earnings surprise on the upside, equities should start closing some of the performance gap with the US. Euro-area risk assets should continue to recover and yields on long-dated government bonds should drift upwards (prices fall when yields rise). Given the strong price appreciation in 2019, euro-area equity valuations look less attractive on an absolute basis compared to a year ago, although macro valuation metrics are still favourable. In relative terms, euro-area equities remain attractive, particularly in France, Germany and Italy. Spain is somewhat less attractive due to the risk of a worsening political and regulatory environment.
Downside trade and political risks remain
On the downside, it is hard to be confident about the outlook for global trade, and Brexit may return as a risk later in the year.
The euro area suffered through an industrial and trade downturn over the last year, with the German economy particularly exposed to the weak auto sector and soft global investment demand. If global demand and trade recover, exports should pick up rapidly.
The trade conflict between the US and China also highlights the fragility of the global trade system. Having settled “phase one” with China, will the US try a similarly aggressive approach with the EU? The EU-US trade relationship is more balanced, much bigger and more complex, and an aggressive US stance could trigger a forceful EU response. Both sides have a lot to lose from such a conflict. The digital services tax and the Boeing/Airbus disputes are current flashpoints, but not enough, in my view, to trigger a trade war. A more likely trigger would be if the US were to impose broad-based tariffs on EU goods. This is a key risk to monitor over 2020 and possibly beyond.
So what’s in the price?
Market valuations probably reflect a relatively slow growth and earnings recovery. Last year’s strong equity returns do not reflect an optimistic earnings outlook or a strong recovery. Instead, they indicate a re-evaluation of risks, notably a perception that trade, recession, deflation and Brexit risks are much lower than was feared a year ago. I do not believe that the market is pricing a strong recovery. If a stronger or earlier-than-expected recovery appears, it could drive earnings and valuations higher.