EuropeJan 11 2017

Steady as she goes for 2017

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Steady as she goes for 2017

Economic recovery continues across most of the eurozone bar Italy, which is dangerously close to falling back into another recession.

Region-wide, surveys of firms’ employment intentions have broken out after reaching a plateau at the start of the year, and this should support consumer spending growth as the boost to discretionary spending from lower energy prices wanes. The demand for credit continues to increase and broad money supply growth has steadied at an annual rate of around 4 per cent to 5 per cent over the last year

The global starting point is also encouraging. Our global leading economic indicator suggests there will be a strong first half of 2017.

Yet, despite all this positive context, there is much to be uncertain about in 2017. There is Donald Trump, Brexit, Italian banks and the price of commodities. 

And then there is a string of elections in the eurozone where anti-EU tickets have a real chance of success, putting at risk the confidence investors have in an economy still being weaned on from life support.

The Dutch start us off in March, France goes to the polls in April and May, Italy may follow suit at some point if the newly formed interim government struggles to rule, and Germany will vote for a new government in September and October.

All of this has the potential to undermine economic confidence, making the spread of likely outcomes for the business cycle wider than usual. The risks posed to the global economy, while serious, are unlikely to result in recession in 2017, but they could quite easily undermine market confidence.

There is a strong correlation between the rate at which investors will discount tomorrow’s earnings into today’s price and the broader economic uncertainty.

In other words, as investors become less certain about the direction of the overarching business cycle, they will become less certain about future corporate cash flows, so demand a higher rate of return. It is surprising then that the rate at which investors are discounting earnings by has fallen sharply over the last two months in spite of what has happened in Washington and Rome. 

More technically, the equity risk premium implied by current market levels has fallen to one of the lowest levels – or rather one of the most sanguine levels – we have observed over the last five years.

So while we recommend staying invested, a cautious approach seems warranted.

Across the Channel, investors will be bombarded with political events in 2017. Eurozone politics were fractious enough before you remember that the Italian banking crisis rolls on and inflation expectations remain worryingly weak.

The pro-eurozone Italian prime minister resigned in December, and the far-right, anti-eurozone Marine Le Pen is likely to win the first round of the French presidential elections in April. While we do not believe that either of these developments poses the existential threat to the eurozone that many commentators are making out, there is still much to mull over, so many investors may start to increase their discount rates. 

However, the Italian ‘no’ vote is another thorn in the side of eurozone progress, but an imminent general election is unlikely.

Few parties other than the anti-establishment Five Star Movement (MS5) also have an incentive to go to the polls. An election may follow if the interim government struggles to pass the ‘Italicum’ election reform agreed last year. Even if the worst happened and the MS5 did gain enough power to call a referendum on European Union membership (this would need a law change first), there is not nearly the same level of discontent towards the EU than there is in the UK.

Eurobarometer survey

The European Commission’s Eurobarometer survey was one of the few that suggested the UK might leave. This survey suggests that most Italians view the EU positively, and are overwhelmingly in favour of the single currency, the single market and a common immigration policy. 

As such, the sovereign bond market’s muted reaction immediately following the electoral reform referendum was right, and similarly, borrowing costs for the eurozone banking sector have also remained unmoved. Credit default swaps (CDS) – default insurance that measures a bond’s credit quality – on the iTraxx Europe senior and subordinated financial index are trading only a few basis points wider.

Yet the planned recapitalisation of Banca Monte dei Paschi di Siena and seven other medium and small banks are now likely to be extremely difficult, especially if there is prolonged policy uncertainty from the tortuous formation of a new government. This increases the chance of recession on the brink of which Italy is already teetering. The fallout from the eurozone debt crisis still drags on and the fix has edged further away.

Meanwhile, equity valuations in the eurozone are not cheap compared with their long-term average or the historical ratio against other regions. Notably, returns on equity are unlikely to improve without a recovery in the still-fragile financial sector.

Earnings momentum is weak and analysts have set a high bar for 2017: earnings per share growth of more than 13 per cent.

Political and equity risks

Given the political risks over the next year, it is difficult to envisage the equity risk premium moving much lower or valuations moving much higher. This means slim protection against any potential negative revisions to 2017 earnings.

Meanwhile. closer to home, Brexit negotiations will lumber on, but in contrast to the US and Europe, investors have started to penalise UK-focused stocks quite conspicuously in terms of near-term profit projections and equity risk premia.

There is limited potential for political loggerheads in Europe and Brexit to send the economic cycle into a tailspin this year, so we feel that capital should remain invested, but that does not mean that stock prices will not fall if events make the policy outlook more uncertain. 

Edward Smith is an asset allocation strategist at Rathbone Brothers

Key points

There is much to be uncertain about in 2017: Trump, Brexit, Italian banks and the price of commodities.

The Italian 'no' vote is another thorn in the side of eurozone progress, but an imminent general election is unlikely.

Equity valuations in the eurozone are not cheap compared with their long-term average.