Most global equity markets are on a tear this year, which has many investors fretting about abundant complacency. The fact is, that despite recent strong gains, I don’t expect a recession anytime soon. The vast majority of major economies are seeing solid growth that continues to improve all the time, even as we navigate event risks as European politics and Brexit. The Fed, during the last meeting in March, has made clear it wants to keep monetary policy accommodative. Expectations for Trump’s economic stimulus are now so low after the failure of replacing Obamacare that further marginal disappointment there won’t collapse sentiment. Furthermore, market expectations are on tax reforms and infrastructure spending. Lastly, the results of Dutch vote should reassure that the populist outcome is not guaranteed to surprise at every political election. The French risk hasn’t gone away, but we should have more faith in the repeated polls that suggest Le Pen won’t win the presidency.
Graph 1 [Source: Bloomberg].
Graph 2 [Source: Bloomberg].
In this article I am trying to tackle the global economic developments with a close focus on the Eurozone.
For the economy as a whole, I believe that despite high valuations on an historical basis (see Graph 1 and 2), equity prices are high due to cash worth nothing (somewhere has even a negative carry), so valuations of ‘real assets’ are higher. This is possible thanks to all-time low interest rates and monetary stimulus (through QE) in the major developed economies. Until the liquidity is abundant in the market it is very unlikely to see a mean-reversion of valuations. We are not seeing (especially in the EU) a shrinking of liquidity any time soon. And even if the FED has started to rising rates, it will be a slow and smooth path at least for the next years.
European Union 2.0
Broadly speaking, Europe is a very good story despite Brexit and the coming elections in France and Germany. If we look at fundamentals, growth of earnings is very solid, the reflationary trade is coming through, and it is synchronized among the different countries. Flows into European equities are following too, meaning that international investors are more interested in this region compared to the recent past.
Brexit could help the European Project
Specifically, in my view, Brexit will be helpful for the European Union. The negotiations with the UK are forcing EU countries to stick together and rethink the Union as a whole. Since now, we have seen a monetary union but the political and fiscal union is not still there and I believe that Brexit has triggered a turning point for the EU in terms of completing the Euro project started in 2000. Companies’ fundamentals are following a positive trend. Banks are now better capitalized, and with a stronger economy will be easier for countries such as Italy and France to make the necessary fiscal reforms and finally boost the economy to get out from the recession.
Data are higher than expected
Overall, the latest indices of economic data are very strong. The index of economic surprises (which tracks how economies are performing compared to predictions) shows more positive surprises than the US. This means that the economy is beating analysts’ consensus that, at this moment, tend to underestimate EU future growth story and this is symptomatic of a general skepticism around the Union. Latest earnings data shows that the biggest EuroZone firms reported a 12% rise in EPS, more than the 5% increase saw across the Atlantic.
Graph 3 [Source: Bloomberg. (CESI: Citi Economic Surprise Index)].
Populism won’t win in Europe
In addition, I see a positive outcome from the elections in France and Germany. As far as I am concerned, in Germany is going to be a ‘win-win’ outcome. In fact, both Merkel and Schulz are pro-European and, after the election, Germany could also abandon some of its pro-austerity rhetoric and increase domestic spending as its allies have asked, benefiting both ties and economy among the Union. More uncertain is the situation in France. During the first two debates, Le Pen has had difficulties to get traction, while pro-euro Emmanuel Macron gained momentum and he is at the top of the pools. Some can argue that this had been the same before the Brexit vote and the Trump election, so I want to focus on other themes in order to explain my conviction of a possible different outcome for France. The Anglo-Saxons countries (UK and US) had inherited an asset-rich and wage-poor model post financial crisis that lead to widespread inequality and rising populism. Meanwhile, as we can see from the chart (Image 1), the European Countries have a far better Gini Index, meaning that populist parties have difficulty to get the same traction in the EU compared to the UK and in the US. Netherland is a clear example where the far-right party lead by Wilders had a very disappointing result, even lower than pools.
Image 1 [Source: usgovteducatorsblog.blogspot.com]
Banks: the Kingmaker
Lastly, banks will play European recovery. The key is that, in the EuroZone, around 80% of overall lending is done by banks and, more importantly, almost 100% of SMEs borrowing come from bank lending. In the next years, with a normalization (steepening) of the yield curve, led by an increase of interest rates and a pick up of inflation, banks can finally see an earnings up-lift thanks to rising interest margins, economy growth and NPLs problem resolution. Interest margins will recover by themselves in a rising interest rate environment. GDP is growing at a solid pace among the EU. And Italian banks are, slowly, shrinking their NPLs huge portfolio making their balance sheets lighter from bad loans. Even if, in the short-term, this is causing a stop of lending activity, it is the starting point for a recovery. And since banks are so important for the European economy, I believe that a recovery of the sector would give the final push outside the recession.