Quarterly Investment Strategy
Europe: Still much political risk on the horizon
Politics have taken centre stage in the Eurozone, rocking Italy and promising testing times in the lead up to the French, German and Dutch general elections.
Economic fundamentals are more sanguine, allowing for a scenario of continued moderate recovery – perhaps even helped by fiscal tailwinds in 2017.
The start of “Brexit” negotiations could hurt UK growth prospects, with cyclical weakness compounding the country’s structural imbalances.
After disrupting the UK and the US in 2016, political winds are now raging across continental Europe. Austria managed to avert an extreme presidential outcome but the constitutional referendum in Italy proved fatal to the Renzi government – leaving the country in political turmoil at just the time when banking sector disarray requires strong leadership. Meanwhile France, Germany and the Netherlands are gearing up for general elections in 2017.
An anti-Euro party victory in one of these countries would clearly test the Eurozone’s sense of unity, and possibly threaten the very existence of the common currency. Other downside risks as we look to the new year include a potential sell-off in sovereign bonds, triggering solvency concerns in the periphery, or a major banking crisis, causing a sharp slowdown in lending growth.
At this point, however, our main scenario for Europe is not that pessimistic. Rather, we envisage the region’s economic recovery to continue at a moderate pace – moderate in absolute terms but quite acceptable relative to potential. GDP growth should turn out similar to that experienced in 2016, albeit with a slightly higher contribution from government and non-financial corporations and slightly lower private consumption growth.
Improved fundamentals, as evidenced by current account surpluses and shrinking budget deficits across most of the Eurozone make moderate fiscal tailwinds possible in 2017. Government spending growth will not be as extensive as in the US (assuming President Trump gets his way), but gone at least is the era of European austerity. As for business investment, it stands to benefit from strong and rising corporate cash holdings, as well as continued central bank support. The European Central Bank (ECB) just extended its quantitative easing program by 9 months, albeit at a slightly reduced pace (monthly asset purchases of EUR 60 bn from April to December 2017 versus the current rate of EUR 80 bn). It also increased the scope of eligible bonds, in a bid to facilitate a steeper yield curve and incentivize banks to grant loans. Conversely, although households’ confidence remains strong, rising oil prices and slowing labour market improvement may hold back personal spending somewhat in 2017
Outside of the Eurozone, the triggering of article 50 and launch of exit negotiations will only add cyclical weakness to the UK’s structural woes, particularly if a hard “Brexit” stance is adopted, leading to complete exclusion from the single market. Switzerland, on the other hand, proved its resilience in 2016, with strong fundamentals offsetting currency strength and banks counteracting the adverse effects of negative rates by raising mortgage rates. 2017 should bring more of the same – although the Swiss National Bank’s leeway to manage upward currency pressure has now become very limited.
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