You are here
Politics takes centre stage
INVESTORS in Europe face something of a dilemma in 2017. On the one hand, the European economy finally appears to be doing well, after years of disappointing growth. But, at the same time, there are several major political risks in the months ahead, at least one of which (the French presidential election) has the potential to derail this economic and market recovery. Negotiations around Brexit are also likely to provide an unsettling backdrop throughout the year, as could further developments in the Greek odyssey.
How should one position for this? First, you need to accept that this will be a politically-driven, volatile market in the run-up to the French presidential elections (April/May). But the market could also rebound after the elections. Second, be prepared for lengthy Brexit negotiations and a likely slowdown in the UK economy. Third, realise that the factors affecting investment in European firms are not just European in origin: Global trends will be important too.
European politics will be particularly important in 2017. We have already had parliamentary elections in the Netherlands. Now we face a much bigger hurdle in the form of the French presidential election, with a first round in April and a second round in May. This will be followed by French parliamentary elections in June and German legislative elections in September. An early election also remains possible in Italy, although this now looks less likely than it did a few months ago.
Of all these impending elections, markets have understandably focused on the French presidential elections. This is not because a shock result is predicted: The polls still suggest that either of the main centrist candidates would beat the National Front candidate, Marine Le Pen, in a second-round run-off. But, if the polls are wrong, a Le Pen victory would be a profound shock to the credibility of the European Union (EU).
But, despite these political concerns, European economic data is looking good. Eurozone leading indicators - most obviously, the purchasing managers' indices (PMIs) - have been rising, in France as well as in Germany, the economic motor of the region. Much "hard" data - for example, industrial production, retail sales and employment - is also pointing to an upturn.
All is not perfect, of course. There is a degree of fatigue around economic reform in Europe and the pace has slackened - as exemplified by Italy's slow moves towards constitutional reform. Governments are also becoming less keen on fiscal austerity, although any upturn in spending is likely to be modest.
Inflation is another development to watch. Recent rises have been driven largely by higher energy prices, and we expect the European Central Bank (ECB) to look through them when considering monetary policy. But core inflation could pick up too and evidence of stronger growth would intensify discussion on future ECB tapering.
Evidence of stronger economic growth has been accompanied by reasonably buoyant equity markets. After a consolidation around the second half of January, European equities have now moved again higher in tandem with US equities.
A weaker euro against the US dollar has provided a tailwind: This is particularly helpful as over 50 per cent of larger European companies' revenue comes from outside the EU. European equities have also been helped by still very low core European bond yields, making them relatively more attractive, given European equities' overall dividend yield of about 3.5 per cent.
Europe's Q4 2016 earnings season also proved generally good. As a result, general market analysts' earnings per share (EPS) forecasts have been relatively stable in the first few months of 2017, in marked contrast to their sharp downward revisions in previous years.
In fact, EPS revisions have been upwards for materials, financials, industrials and consumer discretionary. The price/earnings ratios of the Stoxx 600 and Stoxx 50 also remain close to their average historical discount to the S&P 500 earnings, although the discount on the German DAX index is above historical levels.
Despite this good news, we believe caution will be needed on European equities until after the French election. Then there could be outperformance.
On Germany, we think the focus should then be on export-oriented companies and equities that can benefit from positive consumer sentiment. Relative valuations of European small-cap firms also appear positive compared to the US, given US small caps' increased levels of leverage over the last few years and the likelihood of Fed tightening.
At a sectoral level, we think that there could be opportunities in IT and the energy sector, which could now start to deliver after the trough in prices and investment last year. Within financials, the low yield environment is still impacting margins and investment activity - and the threat of further regulation is still heavy (Basel IV), but it is possible to see some bright areas (for example, Scandinavian financials).
Other sectors, for example industrials, probably need evidence of stronger economic growth and higher government spending to really prosper. We would stay cautious on utilities, however, despite expectations that it would be the highest dividend sector for 2017 on the Stoxx Europe 600.
In some ways, European fixed income has proven more susceptible to concerns regarding European politics than equities. One focus has been on the increased spreads of French government bonds versus German government bonds, but there are also deeper concerns as to what could happen if a Le Pen victory threatened the existence of the euro and outstanding bonds had to be redenominated in other currencies.
Such concerns have unsettled European sovereign corporate bond markets. But if the Le Pen threat is averted, then better-quality European high yield bonds, for example, should benefit from a stable fundamental environment, access to credit markets and still-low default rates.
When the French election is out of the way, market attention is likely to return to the Brexit issue. As I noted at the start of this article, investors need to be prepared for lengthy negotiations and a likely slowdown in UK growth. Up until now, market concerns about the Brexit process have been most evident from the value of the pound sterling. But, as substantive discussions get underway with the UK's EU partners, markets may start to take a more nuanced view of the whole process.
Initially, larger-cap UK equities could benefit from a further weakness in the pound (which boosts profits remitted from overseas subsidiaries), but the UK economy is likely to slow over the course of 2017. Consumption will be put under pressure by higher levels of inflation.
The Bank of England will probably be willing to tolerate some inflation overshoot above its 2 per cent level, given concerns about the impact of higher rates on the economy. Growth in house prices has slowed nationally and there is evidence that - in the face of not only Brexit-related worries, but also sharply higher transaction taxes - prices are falling in the prime London market.
Finally, however, investors need to remember that European developments are not happening in a vacuum. Much will depend on what happens elsewhere - notably as regards US monetary, fiscal and trade policy. W
Tuan Huynh is Chief Investment Officer, Asia-Pacific, Deutsche Bank Wealth Management