Back in January, there were many reasons to believe that the eurozone was on the mend and that the growth outlook was not as dire as many were predicting.
The fading impact of austerity, slow but steady national reforms, the ECB backstopping the region, an improving credit cycle and a weakening euro would all act as significant tailwinds to economic growth.
A few months on and economic momentum is building as data continues to surprise on the upside. The most recent data point is eurozone industrial production, which came in at 1.6 per cent year-on-year – double consensus expectations. Meanwhile, the latest bank lending survey from the ECB confirmed the gradual turnaround of the credit cycle as demand for loans continued to pick up and credit standards ease. The continued improvement in the economy is solidifying investor interest and driving risk assets higher. Up to the middle of April, the MSCI Europe ex UK Index had gained nearly 20 per cent, including dividends, and while the recent pull-back in the market could be attributed to several factors, heightened risk around Greece may have been near the top of the list.
The Greek saga has been unresolved for months, but appears to be nearing an important moment. Either the government reaches a deal and international lenders release some of the withheld aid, or Athens ends up defaulting on the €1bn payment due to the International Monetary Fund in May. However, months of missed deadlines, increasingly fiery rhetoric and unsuccessful negotiations means markets are becoming accustomed to the daily politics of Greece, and an improving economy and action by the ECB will continue to “contain” the threat of default.
Cyclical indicators gauge growth in the region by offering insight into the more promising sectors of the market. New car registrations in the region are nearing their long-term average after a trough back in 2013 and were up 13.4 per cent year-on-year in March. This makes sense as the European car fleet is ageing and cars are being replaced after years of delayed household spending. In Spain, the average vehicle age in 2013 was 11.3 years vs 8.5 years in 2007. But it is not just limited to cars; European households are spending their oil windfall and in many countries they are benefiting from rising real wages thanks to lower prices compared to a year ago. Retail sales growth has increased markedly, running at above 3 per cent year-on-year since December 2014.
European equities are not as attractive as they once were from a valuation perspective. Forward price/earnings ratios have risen sharply since the start of the year as equity prices have overtaken corporate earnings. There will be room for further improvement in this market, but future returns will depend on earnings growth.
Consumer sectors should do well given the increasing strength of the European consumer, and the consumer discretionary sector of the MSCI Europe ex-UK Index was the strongest-performing segment of the market in the first quarter, gaining 21.9 per cent. Financial companies tend to act as bellwethers for markets and will do badly if deflation becomes entrenched or the domestic recovery goes into reverse, but they have already benefited from the improving credit environment and, with a beta above one, stand to gain disproportionately if the eurozone recovery surprises on the upside.
Investors looking to make the most of the improving economic environment in continental Europe should take a strategic approach to the market after this year’s surge in price and swift move higher in valuations. Worries about Greece will continue to bubble away, but this should not put investors off European equities, but instead it should encourage a greater focus on earnings. The parts of the equity market that are more sensitive to the economic cycle are likely to see the strongest revenue growth against an improving economic backdrop.
Kerry Craig is global market strategist of JP Morgan Asset Management
