‘No change’ – a winning formula for Europe?



​We have passed the first anniversary of the UK’s puzzling (and ominous) vote to leave the EU, and we are only a few months away from the first anniversary of the election of Donald Trump. It was feared that these two events would lead to a general rejection of ‘status quo’ politics, ushering in a kind of latter day ‘New Deal’ across Europe and America. The reality is rather different.

In the UK, the main cheerleaders for Brexit have either left the scene or are now slowly accepting that many, if not all, of their promises were unachievable. Some of them are now trying to figure out how they go about breaking the news to those they have misled. There will be more talk of ‘long transition periods’ in the months ahead as reality dawns. In the US, doubts are also growing about precisely how much of President Trump’s ‘brilliant’ economic plan is actually achievable.

Brexit bluster eclipsed by European pragmatism

The relevance of these factors is in the comparison. While many have focused on headlines about Trump and Brexit, in the background progress in Europe has been very much a case of “plus ça change, plus c’est la même chose”; roughly translated as “nothing really changes”. Economic growth has continued to pick up in Europe, outside the UK, and discussions about whether or not the European Central Bank (ECB) can start to unwind its campaign of economic stimulus (QE) have, as expected, begun.

With investors positioning for the end of ‘ultra-easy’ monetary policy in Europe, yields on 10-year German government bonds (bunds) rose to over 0.5% in July 2017, a notable change from the end of 2016, when they briefly moved into negative territory. While some might see this as a threat to equity markets, it could more realistically indicate the improving trend in Europe’s economies, perhaps even signalling a return to some semblance of normality. This improvement has begun to filter through to corporate earnings as well, one of the factors behind the positive moves in equity markets on a year-to-date basis.

Avoid the euphoria trap

While investors have rightly started to notice the improvement in Europe there are, however, still quite a few clouds on the horizon. First, it is still far from clear whether the tailwind in Europe’s economies is as strong as markets might be anticipating. Reporting for the second quarter was met with a mixed reception. Atlas Copco, one of the world’s best engineering companies, reported strong growth, but not enough to match aggressive expectations. This has been a trend for quite a few companies – perhaps a helpful reminder that quarterly reporting is not necessarily that helpful for businesses that are simply not run on the basis of three months of performance.

Second, the UK and US – two of the countries in arguably the most uncomfortable political situations – have also conceivably been using devaluation as a tool to mitigate weak underlying economic fundamentals. The weakness of the US dollar versus the euro over the past six months has also meant that profits in US dollars have turned from a tailwind to a headwind – a 180 degree wind-shift, as chart 1 shows (with the US dollar falling 11.9% in value versus the euro over the six months to 1 August 2017). This has reduced the value of any profits made by European companies operating in the US.

Chart 1: US dollar weakness has hit European companies operating in the US

Source: Janus Henderson, Thomson Reuters Datastream, 1 August 2016 to 1 August 2017. A rising line indicates that the US dollar is weakening, which reduces the value of US earnings for European companies.

Twin tailwinds for European banks

In terms of recent results, earnings in “reliable growth” names have generally met expectations, but this has often not been enough in those cases where valuations are high – the market continues to like ‘quick recovery’ names.

One area of the market that may be in a positive situation for a little longer is financials. Stronger economies are reducing the level of default provisions and, as we saw in the US, investors are willing to buy on the idea that higher interest rates should be positive for net interest margins. Together, these factors have contributed to why banks have performed slightly better in 2017. But the nervousness over whether growth might peter out too quickly is tempering enthusiasm for the sector.

The next few months may help clarify the answers to quite a few questions for European equities. It then remains to be seen whether markets will continue on their now-familiar roller coaster ride, or whether investors will begin to look through what some might perceive as short term ‘noise’.

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