Quarterly Investment Strategy  

17/10/2016

Europe: economic recovery holding up – risks are once again political

image1.JPGIn a nutshell:
 

While admittedly not impressive, Eurozone economic trends are defying doomsayers: GDP growth is currently above its potential and close to that experienced in the US.

Consumption, at its strongest since 2010, is the main economic engine, on the back of solid wage growth.

Monetary support should be maintained but not increased – absent negative political developments.

Europe continues be judged very severely by investors, entrepreneurs and civilians, who see it as the problem child of the world economy. Negative complacency on the region, on its construction and its common currency, is well entrenched.

Economically speaking, though, European dynamics are actually quite acceptable. It is true that GDP growth is much slower than in the past and, at 1.6%, can hardly be termed satisfactory. Still, it is greater than potential (as calculated per demographic and productivity trends), therefore sufficient to stimulate job creation – and close to the current US level.

We expect domestic demand to continue to be a key driver of the Eurozone recovery this year. There is greater underlying strength in spending than at any time since 2010, supported by better employment growth. The Eurozone wage bill (total employee compensation) is rising at a 2.8% clip – the highest rate in almost a decade – with nominal GDP also growing at 3%. This is not an economy in intensive care requiring experimental and radical doses of shock therapy by the European Central Bank (ECB). Fears of renewed deflation seem overdone.

As such, supplementary assistance from the ECB should not be counted upon, at least as regards interest rate cuts and asset purchases. Ongoing programs will likely be prolonged beyond their current March 2017 term but, assuming that the sizeable political risks on the horizon (referendum in Italy, elections in France, Germany, and possibly Spain) do not take their toll and economic growth continues to exceed potential, next year could well see us question the appropriate timing for the ECB to start withdrawing its stimulus.

Alternative avenues of economic assistance are being explored globally, notably via the public sector. For Europe the risk of such support is that it be unsynchronised and/or poorly executed.

How will the UK (and Europe) fare post “Brexit”?

It is becoming increasingly likely that the UK will indeed exit the European Union (EU). Despite the benign outcome so far, we expect some economic deterioration going forward. The lift to UK exports and multinationals from the weaker pound should not prove a sufficient buffer for the broader economy. The UK will also probably cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign direct investment. As regards the City’s importance as a financial centre, EU member states should slowly introduce regulations that force the financial industry – at least that dedicated to transactions in euros – out of London.

A critical factor with respect to all these questions will be the actual form that “Brexit” takes when it happens. The first signs on this front are worrisome, as the UK government appears to be leaning towards a fairly “hard Brexit”, which would take the country out of the single market and possibly also out of the customs union.

In response to growing uncertainty and slowing economic trends during the coming quarters, we anticipate that the Bank of England (BoE) will become yet more accommodative. Support is also to be expected from the new government, whose autumn statement will provide clues as to the future identity of the British economy.

Elsewhere in Europe, the UK vote inflicted little immediate economic and financial damage to major economies. It did, however, heighten the vulnerability of the peripheral economies by weakening the credibility of the Eurozone construction. Speculation on these countries’ future has again become rampant, with a particular focus on Italy.

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