The last six months have been nothing short of eventful, characterized by trade spats, two rescheduled Brexit deadlines, major leadership shakeups and elections, and a continued slowdown in growth – the list goes on. In this piece, as a follow-up to our global mid-year outlook titled Navigating a Maturing Cycle, we provide our latest thinking on the European region—a macro and market look at its struggles, bright spots, and potential opportunities.

Manufacturing and trade exposure has thrown Europe off its game

Europe's economic slowdown since late 2017 has been painful for both policymakers and investors. Just when the economy seemed on the brink of escaping deflationary forces, a deterioration in the global economic and political environment has brought challenges for Europe's economy. Specifically, the Eurozone, the largest chunk of Europe’s economy, is heavily exposed to international trade, which accounts for a significant portion of its GDP compared to other areas.

Europe is heavily exposed to trade

Source: Eurostat, CNBS, China Customs, BEA, Haver Analytics. Data is as of March 31,2019.
Shows Europe is heavily exposed to trade in comparison to China and the US. Goods exports as a % of GDP
In this vein, much of the region’s economic activity relies on the production of investment goods—and activity has been declining across the board.

Trade-related economic activity has deteriorated meaningfully

Source: IHS Markit, Haver Analytics. PMI: Purchasing Manager Index. Data is of June 30, 2019.
Shows Eurozone manufacturing PMI, new export orders
With its exposure to trade and manufacturing, ongoing trade tensions and the slowdown in the Chinese economy have produced weakness in the Eurozone. However, while indicators around the deteriorating global economic environment look ugly, they are far from the full story. Even as industrial production and trade have slowed, employment in Europe is robust, job vacancies remain high, consumption appears strong and confidence in the services side of the economy seems healthy.

Manufacturing has taken a hit, but services are holding on

Source: OECD, Haver Analytics. Data is as of June 30, 2019.
Shows Manufacturing has taken a hit, but services are holding on. Eurozone confidence indicators, % balance

This domestic resilience, and clear support coming from policymakers at both the national level and the European Central Bank (ECB), suggests that growth in Europe could stabilize. Importantly, this would be an era of modest growth, rather than one of cyclical reacceleration. In other words, while indicators attached to weakness in manufacturing and trade seem to have reached depths last seen during the financial crisis, some cyclical indicators have stabilized at levels suggesting the region could achieve moderate expansion.

As we mentioned, Europe has been affected by China’s slowdown due to its exposure to trade and manufacturing. Over the last year, Chinese policymakers have employed stimulus to stabilize its own economic growth. If the Chinese economy finds its footing, European growth could also benefit, particularly if global business investment and other cyclical areas of the economy improve.

Lower for longer: a word on monetary policy

Amid a softening growth environment, political unrest and still tepid inflation, the ECB is also cautious. Notably, the market’s expectations for the beginning of the ECB’s hiking cycle have been pushed back. This has been a meaningful drag for the Euro and Eurozone banks, among other assets.

It now seems that additional easing is likely in the near future. Importantly, ECB President Mario Draghi has signaled that more accommodation would be needed if growth and inflation expectations don’t improve. Furthermore, investors seem to expect the appointment of his successor—current International Monetary Fund chief Christine Lagarde—to continue his “whatever it takes” mantra to support the European economy. The ECB still has a few levers to pull in its toolkit, such as additional rate cuts and restarting quantitative easing. Which levers it might pull remains to be seen.

ECB Deposit Rate and Expectations

Sources: European Central Bank, Bloomberg. Data is as of June 30, 2019. Market expectations represent the 1-day EONIA (the 1-day interbank interest rate for the Eurozone). “Today” refers to the date June 30, 2019.
Shows ECB deposit rate and expectations

On all of our minds: the impact of European politics

While stabilization in the macroeconomic backdrop could improve the growth picture for Europe, political barriers remain a threat to consumer and business confidence. Two issues stand out from our perspective: 1) Brexit and 2) tensions over the Italian budget.

First: Brexit. No clear resolution appears in sight for the current impasse. With the October 31st deadline looming and a new UK prime minister soon taking the helm, the changes needed to avoid “no deal” or a protracted extension remain unclear. Uncertainty over the future relationship between the European Union (EU) and UK is abound, and some evidence suggests this is already impacting the economy of the UK, and to a lesser extent, that of the EU. Tail risks will likely continue to chill animal spirits, and the possibility of a violent market reaction in response to the conclusion of the Brexit process remains.

Second: Italy’s budget. Over the last year, Italian government and European officials have clashed over the scale of Italy’s budget deficit. The recent economic slowdown hit Italy hard, and the country even entered a short-lived recession earlier this year. With growth slower and tax revenues weak, Italy’s planned spending looked like it could result in a larger deficit than initially planned or permitted under EU rules. While the European Commission recently ruled that Italy wasn’t in breach of the EU’s fiscal rules (saving the country from sanctions), there is still a pretty sizable difference in funding costs between Italy and other members of the Eurozone. Markets likely wouldn’t react well to such a significant and/or sudden widening of funding cost spreads.

Investment conclusions: Revisiting our three themes, with Europe in mind

In our global mid-year outlook, we identified three themes that we are focused on. 1) Participation with protection; 2) Harvesting yield; and 3) Finding growth in a low-growth world. Here, we revisit each of these themes with a lens on Europe.

1.       Harvesting yield in a low-yield region

As most assets appear at or near fair value, we are focused on generating a return from yield rather than capital appreciation. However, it’s no secret that bond yields in Europe are low—after all, German 10-year Bund yields are hovering around all-time lows. But dividend yields remain high. Moreover, relative to the broad market, dividend growth stocks tend to outperform during times of market stress. Shifting some equity exposure into companies with an ability and willingness to increase dividends paid out to shareholders could help shield investors’ returns.

While bond yields are at record lows, dividend yields remain high

Sources: Stoxx, Bloomberg. Data is as of July 3, 2019.
Shows bond yields are at record lows, whilst dividend yields remain high

2.       Participate with protection

After 10 years of strong returns, we believe it is time to add more protection to portfolios—and there is a range of ways to do so. We think a focus on quality, both in stocks and bonds, is prudent. Higher-quality securities tend to outperform lower-quality ones in times of market stress. We also suggest adding duration in fixed income—for example, euro-denominated investment grade corporate bonds can offer 100 basis points in yield over German Bunds at a 10-year maturity. This can support portfolios should markets take a turn for the worse. Other non-correlated asset classes could further cushion portfolios from equity losses. Finally, begin to rotate from stocks to bonds. It is too early to do this in a wholesale fashion, but we believe it is time to gradually change the composition of multi-asset portfolios.

3.       Finding growth in the low-growth continent

While growth in Europe has cooled, looking beyond the macro reveals many companies in the region are thriving. Home to key multinational corporations, Europe’s equity market remains a rich source of exposure to many regions, themes and sectors. Furthermore, much of Europe’s economic dynamism is reflected in small companies. While large cap indices have underperformed their U.S. counterparts over the past 20 years, small cap indices have outperformed, beating their U.S. equivalents by about 25% over that time frame.

 

 

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All market and economic data as of July 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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