World investment outlook 2017: Europe

The world investment outlook is written by Russ Mould, AJ Bell Investment Director and contains a wealth of information on the world financial markets and events to help with your investment strategies in 2017.

Here he considers the outlook for Europe.

The European Central Bank continues to come up with creative monetary solutions designed to combat weak growth and sticky unemployment, all the while stoking inflation. Success has been relatively elusive so far, with the result that European stocks remain cheap relative to other major developed markets, notably the USA.

The three key issues for 2017

• Elections are due in the Netherlands, France and Germany and any shift toward anti-EU parties could dampen sentiment
  
• The European Central Bank is extending its Quantitative Easing (QE) scheme to December 2017 and it remains to be seen whether monetary stimulus can help a struggling economy
  
• Banking shares are ending 2016 on the up and a sustained recovery in this vital sector could be a good sign, although any renewed weakness would be a worry
  

Politics

No sooner had Britain voted to leave the European Union on 23 June, the Dutch Party for Freedom and France’s Front National, led by Geert Wilders and Marine Le Pen respectively, demanded that their countries held a similar referendum.

Europe’s leaders ignored those calls but in 2017 the French, Dutch and German electorates will get to have their say and all three ballots could shape short-term sentiment toward European financial markets.

France’s incumbent President, François Hollande, is not even running in the French poll and the Netherlands’ Mark Rutte has a fight on his hands, while even Germany’s Chancellor Angela Merkel will face a stiff challenge from the upstart Alternative für Deutschland as she runs for a fourth, four-year term.

Italian politics remain fractious after the fall of Prime Minister Matteo Renzi but at least Spain now has a Government, albeit a minority one under the pro-Europe Mariano Rajoy of the People’s Party (PP), while December’s re-run Austrian Presidential vote offers the Eurozone additional succour. Green Party member but independent candidate Alexander Van der Bellen fended off the anti-EU Freedom Party of Austria’s (FPÖ) Norbert Hofer for the second time.

Economics

The European Central Bank has just one mandate – price stability (unlike the US Federal Reserve, which has to juggle employment and inflation). Unfortunately the central bank is failing on the inflation front, despite a series of interest rate cuts and the launch and then expansion of a Quantitative Easing (QE) programme since President Mario Draghi’s summer 2012 assertion that he would do “whatever it takes” to preserve the euro currency.

Inflation, as measured by the harmonised consumer price index (HICP), is nowhere near Draghi’s 2% target although there is at least some semblance of a trend that is going in the correct direction.

ECB continues to undershoot its 2% inflation target

Source: Eurostat

The same can be said with regard to unemployment. The aggregate joblessness rate for the 19 users of the euro has finally crept back below 10%, so there is some good news here, although Greece and Spain are still suffering and youth unemployment remains a massive social, economic and political problem in these two nations, as well as in Italy and Portugal in particular.

EU unemployment stands at seven-year lows

Source: Eurostat

The jobless figures also serve to heighten both the importance of the escalating refugee crisis and the pressure on the ECB to magic up some growth for somewhere, even though ECB President Mario Draghi himself regularly insists that monetary policy cannot do all of the heavy lifting on its own.

Draghi has just extended the ECB’s Quantitative Easing (QE) scheme for the second time, from March to December 2017, although he has tapered the monthly amount of monetary stimulus from €80 billion to €60 billion.

It is encouraging that the ECB feels the Eurozone can get by with a little less help, but worrying that the central bank still feels it has to buy time so heavily-indebted sovereign states can get their house in order, especially as that it does look as if that time is currently being used poorly.

Italy’s banking woes are evidence of this. Non-performing loans represent an estimated 15% to 20% of total loans, or around one-fifth of Italy’s GDP. Its economy continues to struggle as a result and no wonder.

Markets

Italy’s debt problems are also being reflected in the share price performance of its biggest banks. Bondholders and shareholders still face the threat of a state-backed bail-out at Monte Paschi di Siena in particular, especially as EU rules stipulate that any Government intervention must be preceded by possible haircuts and debt-for-equity swaps.

Concerns over their exposure to Italian banks has weighed on other lenders, notably Germany’s Deutsche Bank and Switzerland’s Credit Suisse, whose shares briefly plunged below their 2007-09 financial crisis troughs in the autumn.

Both then rallied, helped by hopes for a stronger economy in 2017. Breaking the negative feedback loop, whereby a weak economy weakens the banks, which threatens consumers’ savings and spending plans and in turn further weakens the economy, is a key test for the Eurozone in the coming year.

A recovery in the European banking sector would be a welcome sign for 2017

Source: Thomson Reuters Datastream

Besides a soggy economy and brittle banks, the Eurozone’s stock markets have also been held back by as yet (entirely unfounded fears) that the euro currency was about to collapse and the EU itself break-up, perhaps along North-South lines, creating a ‘twin-track’ or ‘two speed’ bloc.

As a result, European stocks have continued to trade at a large discount to their international peers, based on traditional price/earnings multiples. According to data from Bloomberg, the Eurozone, as benchmarked by the Stoxx Europe 600 index, comes at a valuation discount to the US and UK and offers a higher yield than America, based on analysts’ consensus estimates for 2017.

EU equities trade at a valuation discount to the US and UK for 2017

Source: Bloomberg

Such a discount is historically normal, however, and the problem is finding a catalyst that may unlock what value is there. Improved performance from the banks and the broader economy would help.

When it comes to the economy there is at least one quick rule of thumb. Belgium’s Courbe Synthétique confidence indicator looks to be an uncannily useful guide to the fortunes of the Euro Stoxx 600 index and it can be found on the National Bank of Belgium’s website on around the twenty-first of each month.

Belgium's Courbe Synthétique is a good indicator for Eurozone equities

Source: National Bank of Belgium, Thomson Reuters Datastream

Bulls of European equities will be hoping that the dip witnessed following the UK’s vote to leave the EU was a blip and that the subsequent recovery offered a more encouraging trend.

Top performing funds

Best performing Europe ex-UK Large Cap Equity OEICs over the past five years

Source: Morningstar, for Europe ex-UK Large-Cap Equity category.
Where more than one class of fund features only the best performer is listed.

Best performing European investment companies over the last five years

Source: Morningstar, The Association of Investment Companies, for the Europe category.
* Share price. ** Includes performance fee

Best performing Europe Large Cap Blend Equity ETFs

Source: Morningstar, for Europe Large-Cap Blend Equity category.
Where more than one class of fund features only the best performer is listed.

Read more from our world investment outlook 2017 series:

World investment outlook 2017: UK

World investment outlook 2017: USA

World investment outlook 2017: Japan

World investment outlook 2017: The rest of the world