Europe’s economy: on the road to recovery?

Investors in the region have been required to have a little more patience as Europe lagged the US and UK in terms of economic expansion.

Jeff Taylor, Invesco Perpetual’s head of European equities calls it a “broad-based economic recovery” taking hold in Europe. 

“In the third quarter of 2017, the region posted its 18th consecutive GDP quarterly expansion,” he points out. “On a yearly basis, latest GDP growth hit 2.5 per cent, the best since early 2011. 

“The drivers behind this recovery are predominantly domestic. This is a fundamental break from the recent past, when growth was largely dependent on exports to faster growing parts of the world.”

He confirms: “While Europe’s recovery from the crisis years kicked in later than in the US, it is now firmly on track thanks to a steady, expectations-busting pick-up in private consumption and more recently investment. Banks are lending again and unemployment is falling.”

Figure 1: EU28, euro area and US GDP growth rates, percentage change over the previous quarter

Source: Eurostat

Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers, observes: “Growth in the Eurozone is at its strongest since 2011. 

“Moreover, growth hasn’t been this broad-based since the birth of the single currency, as evidenced by the very low dispersion of growth rates and Purchasing Managers Indices (PMIs). We expect domestic demand to remain the main driver of growth in 2018. 

“On the consumer side, a continued improvement in the labour market is likely to continue to support consumer spending.”

Brexit shock in store?

Russell Investments’ senior investment strategist Wouter Sturkenboom is equally convinced the economic recovery in the eurozone is not only firmly established, but also self-sustaining and robust. 

“As such, it would take quite a large adverse shock to knock the recovery off course,” he predicts. “We don’t expect that to occur, however.” 

The elephant in the room, of course, is Brexit.

Does a ‘hard’ Brexit scenario or simply the prospect of the negotiations being dragged out for longer, have the potential to upset Europe’s recovery? Or is the eurozone area largely immune? 

Mr Sturkenboom says: “We acknowledge that an acrimonious divorce between the UK and EU could certainly impact growth negatively, although it would probably not be enough to cause a recession. We don’t expect that to happen.”

A ‘no deal’ scenario would be devastating for the UK economy, damaging also the EU.  Léon Cornelissen

The balance of trade between the UK and Europe may provide the answer as to whether Europe will feel any negative effects from the UK’s departure from the EU.

Brexit is a risk factor, according to Léon Cornelissen, chief economist at Robeco, who notes that 15 per cent of EU exports are going to the UK, so a Brexit-induced recession in the UK “would damage EU growth, probably without derailing the upswing”. 

He believes: “It all depends on the nature of the exit. A benign scenario would be that the UK would remain for all practical purposes a member of the EU (like Norway) except as a non-member and rule-taker for years to come, say five to 10. 

“In the meantime, negotiations for a comprehensive trade agreement post-EU-membership could take place (and the Irish border porous for the time being). This shouldn’t hamper growth.” 

But he warns: “A ‘no deal’ scenario would be devastating for the UK economy, damaging also the EU, which, however, would benefit from a transfer of business investments to the largest consumer market in the world.”

Keeping it in perspective

Frankfurt in Germany and French capital Paris have been identified as cities that could benefit from financial services firms relocating their headquarters, or simply large swathes of workers leaving London for elsewhere.

Even if the UK were to leave on a ‘cliff edge’ hard Brexit, this is unlikely to have much of an effect, apart from on a few sectors which are dependent on UK exports or imports.Olly Russ

But Olly Russ, European income fund manager at Liontrust, argues while the UK is a large part of the EU economy, it is not a crucial part of trade for most eurozone countries. 

He explains: “Even if the UK were to leave on a ‘cliff edge’ hard Brexit, this is unlikely to have much of an effect, apart from on a few sectors which are dependent on UK exports or imports. 

“In reality, the vast bulk of UK economic activity will remain exactly as before, and so the impact is likely to be very limited indeed.”

There have been some reports of wrangling over the supposed Brexit bill that the EU wants the UK to pay before it can negotiate the terms over which it leaves the union.

Guy Foster, head of research at Brewin Dolphin, suggests: “Brexit will cause some political challenges and the increased EU budget for remaining members is likely to be a frustration if it is not compensated through a hefty UK exit bill. 

“But either way it will be unlikely to change the trajectory of European growth materially. The UK makes up less than 10 per cent of eurozone trade by its broadest definition.”

There are those who believe it is entirely impossible to make any predictions at all about the outcome of the Brexit negotiations and the effect on either the UK or Europe.

Tristan Hanson, manager of the M&G Global Target Return fund, asserts: “There are simply too many moving parts and too little clarity on what future arrangements will exist in order to make a judgement. 

“In the event of a hard Brexit, the eurozone might benefit from certain business activities shifting from the UK to the continent but, conversely, euro appreciation versus sterling might offset some of that positive impact, as could disruptions to trade activity. 

“It is very possible that other factors affecting eurozone growth have greater significance, such as growth in China or changes in monetary policy.”

Other headwinds

Investors may wonder why China could possibly affect the economic outlook in Europe. After all, the country appears to be on a steady footing after concerns a couple of years ago that it was in for a ‘hard landing’.

As the euro appreciates, it’s going to present a headwind to the recovery of corporate profits.Dylan Ball

Mr Sturkenboom explains: “China is a risk because it could decide to focus on reform instead of growth. The accompanying slowdown which would entail would weigh on eurozone growth, which is quite exposed to trade with emerging economies.”

While it may be a potential headwind, it is one he is monitoring and is not convinced it will derail the region’s recovery.

Most of the main elections in Europe have been and gone, with a decisive victory for Chancellor Angela Merkel in Germany and the election of president Emannuel Macron in France helping assuage fears of a resurgence in populism.

The upcoming Italian elections may still shake things up politically in Europe. 

The populist party Five-Star Movement had long been expected to make significant gains in the country’s general election this year, although this has been thrown into doubt since it suffered poor results in local elections a few months ago. 

Mr Russ says: “The 5-Star movement wavers somewhat over its commitment to a referendum on the euro, but following Marine Le Pen’s abandonment of the issue after her electoral failure in France, the issue in Italian politics seems to have been put on the back-burner even among the radical populists. 

“Whoever wins the election therefore (insofar as any one party does win Italian elections), a euro referendum remains unlikely.”

Perhaps the euro is the biggest threat to the stability of Europe’s economic upturn.

Dylan Ball, executive vice president, portfolio manager, Templeton Global Equity Group, acknowledges the strength of the euro is a key risk.

He comments: “As the euro appreciates, it’s going to present a headwind to the recovery of corporate profits. Broadly, every 10 per cent appreciation in the euro will take 6 per cent off corporate earnings.

“Having said that, as contrarian investors, when the euro/dollar was getting down to the 1.05 level, we were finding many European ideas and putting them into the portfolios.”

eleanor.duncan@ft.com