Continental creep

A string of underwhelming economic data, combined with unsettling events for Portugal’s banking sector, resulted in a level of weakness in both European equity and bond markets not seen for a while. I would argue that the latest developments in Portugal are more noise than anything. This is not a resumption of the eurozone banking crisis and the likelihood of contagion is pretty low, thanks to the actions of the European Central Bank over the past two years. But given the skittish response from the market recently, the question to ask is: have circumstances changed and is an adjustment required? My answer is no. Coming into the year, the expectation for the eurozone was for a weak and fragile recovery, and that is exactly what we are getting.

It is difficult to get away from the fact that economic momentum in the eurozone has slowed over the first half of the year, most notably in France and Germany. But the crucial fact is that slowing down is not the same as stopping. The economy is still moving forward, albeit at a crawl. Around the eurozone, the economic data for May was not great. Retail sales pointed to sluggish growth and industrial activity contracted sharply. This has led some economists to lower their expectations for growth in the second quarter. However, those economists are probably the same ones that had over-optimistic expectations in the first place.

It is not all doom and gloom. At least some of the slowdown in industrial activity in May can be attributed to the timing of public holidays. A number of these fell on a Thursday, leading to the use of “bridge days” to extend the summer weekends. France has three such days in May. This means some of the negative in the latest data should be unwound in the June figures. Furthermore, the weaker numbers do not corroborate with the still-robust purchasing managers’ indexes for manufacturing. While PMIs have come down from the highs in January, they remain well above the key level of 50 which separates expansion from contraction.

It is not all doom and gloom. At least some of the slowdown in industrial activity in May can be attributed to the timing of public holidays

Meanwhile, Greece looks to have returned to growth and the Spanish economy is going from strength to strength. The Spanish unemployment rate is still more than 25 per cent, but the labour market has added nearly 400,000 new jobs in the past year, while the tax reform package could provide up to €9bn (£7bn) in relief to households. The reduced drag from fiscal tightening – and the boost from improving sentiment in some countries – should also add to growth. So, although the regional economy is looking less strong relative to a few months ago, in absolute terms things are still OK and the very moderate pace of economic expansion should continue. A more expansive outlook for growth is still limited by the continuing competitive adjustments, large debt overhangs and weak credit growth. This is still a shorter list of headwinds than it would have been if I were writing it a year ago.

The recent bout of market consolidation should be viewed as healthy rather than a reason to rush for the exits. Investors should remember that markets do not move in a linear fashion, especially during earnings season. European markets have been driven by multiple expansion, as investors have rushed into buy relatively cheap assets in an economy that looked to be reviving. However, now that markets are no longer cheap, evidence of corporate earnings is sorely needed to enable further gains and justify current market levels.

The ingredients for better earnings are in place and the drags to weaker past earnings performance – such as feeble growth from emerging markets and a strong euro – are moderating. The key for many companies, however, will be in controlling costs. By keeping costs down, even a reasonable increase in the top line can translate into higher profit margins. The moderation in economic growth recently may play through into earnings and while expectations are for positive earnings growth, the strength of those earnings should be pared to match economic performance.

Kerry Craig is global market strategist of JP Morgan Asset Management