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Europe – The darkest hour is just before the dawn

The European Central Bank (ECB) is embarking on quantitative easing (QE) at a time when tailwinds are already beginning to build behind the euro area economy. Threadneedle Investments’ fixed income fund manager Martin Harvey asks if we can dare to dream of a brighter 2015.

Last year, we suggested that the eurozone economy was not destined for Japanese-style deflation as long as economic momentum was maintained and the ECB stood firm. Twelve months on, and the pendulum of expectations has swung against our view, following a weak economic performance and headline inflation turning negative. We believe, however, that there are reasons to be more optimistic this year, with important implications for markets.

2014: A spiral of despair

Headline inflation continued its path lower throughout 2014, chiefly due to weakness in food and energy prices. Growth expectations were also dashed as the Ukraine crisis and ebbing global demand sapped economic momentum. It is not surprising then, that estimates for long-term potential growth have been pared significantly leading to growing fears that the eurozone economy is condemned to a long period of stagnation and deflation. Consequently, market pricing currently implies that interest rates will stay below 1% until 2023, and inflation over the long run is likely to be 1.5% rather than 2%. 10-year German government bond yields now offer a yield of 0.35%. But stepping back from the downward spiral of lower inflation and lower interest rates, we feel there are reasons to be more positive in 2015 than was the case.

2015: Curb your lack of enthusiasm

First, while inflation has been driven lower by the price of goods (largely food and energy), service price inflation has remained relatively stable, suggesting that all is not lost. Indeed, the huge fall in energy prices experienced in recent months will provide a boost to real incomes and subsequently consumption at a time when this metric is already improving. Furthermore, following the restructuring of the banking system over the past two years, the prospects for credit growth appear better, with surveys of credit demand and supply moving into positive territory. Corporate loan growth has yet to turn positive on an annualised basis, but on the current trajectory should do so in the coming months. With these dynamics, domestic demand should be well-supported in the coming year.

With respect to the external sector, the 10% depreciation of the euro over the past year should provide another tailwind. Studies have shown that exchange rate moves are a less important determinant of export growth than the strength of global demand, but nevertheless a 10% depreciation is surely more favourable than the appreciation that existed in the previous period. Furthermore, we have learned from Japan’s recent experience that a weaker currency will give a direct boost to earnings for companies that sell their products abroad, boding well for corporate profits. These domestic and external factors increase the potential for an upside surprise as we move through 2015.

The sharp fall in inflation expectations stoked sufficient fear in the minds of the ECB governing council to spark the initiation of measures that would have been unthinkable only a few months ago. The shift to negative deposit rates, the injection of liquidity via targeted repo operations (TLTROs), and the expansion of asset purchases to include government bonds (quantitative easing) will contribute to a meaningful easing of monetary policy. Given the already low level of interest rates, there is widespread scepticism regarding the effectiveness of these measures, but the aggressive change in the ECB’s stance should send a strong signal that it is serious about meeting its inflation target. The ECB balance sheet has contracted for two years, but will now be forcibly increased in a manner akin to the policies pursued in the US, UK and Japan. This is a meaningful development at a time when momentum should already be improving. We have accordingly revised up our forecast for eurozone GDP to 1.5% for 2015 from 1% previously.

Many of the current tailwinds are relatively short term in nature, whereas over the longer run structural reforms hold the key to improving potential growth in the euro area. Encouragingly, the strong outperformance of the Spanish economy over the past year is in part testament to labour market reforms enacted during the crisis. Spain is likely to perform strongly again in 2015 as domestic demand strengthens further. We are also becoming more optimistic over Italy’s prospects, where after years of economic stagnation and political stalemate, Matteo Renzi appears to be making real progress in reforming both the labour market and the electoral system. Both of these countries’ governments have some way to go to ensure long-run debt sustainability but steps in the right direction are to be welcomed.

Political risks remain high

Alas, with Europe, we always need to highlight the downside risks, which remain considerable, most notably relating to politics. Many European governments face general elections this year and will need to navigate the rise of populist anti-EU sentiment. Most immediately, of course, this is evident in Greece where the left-wing Syriza party has been elected on a manifesto of increased public spending that appears to set Greece on a collision course with the EU. How this resolves itself will have implications for Spanish and Portuguese elections later in the year, while the general rise of such anti-austerity movements is detrimental to prospects for structural reforms and coherent EU policy. Tensions with Russia also continue to cast a dark cloud over the economy, and will continue to be a concern for companies when assessing investment plans. Any further escalation would be detrimental to both economic and market confidence. We will be watching developments very closely, given that risks emanating from political factors remain squarely to the downside.

Market implications

A more constructive economic outlook could have important implications for European markets. Equity valuations remain attractive and the rise of the market in early 2015 already points to increased investor confidence. M&A activity continues apace and the IPO pipeline is fit to burst, as easy financing conditions make deals attractive. Interestingly, small caps are trading at a discount to large caps for the first time in many years, offering an opportunity for risk-seeking investors with a long-term horizon.

In bond markets, depressed yields make it difficult to make the case that there is great value on offer anywhere, although the comforting prospect that rates are set to stay low, alongside an improving growth outlook should offer further support to corporate bonds, particularly at the lower end of the ratings scale.

We believe that peripheral government bonds should fare well in an environment of improving fundamentals and explicit central bank support, although politics will continue to be the main source of downside risk. Core rates offer very limited scope for further performance, and although yields are unlikely to rise significantly against a backdrop of strong buying from the ECB, an adjustment to higher yields to reflect a more favourable economic outlook would lead to negative returns.

Implications for risk assets

It is easy to be pessimistic about the prospects for the eurozone, but we believe that, notwithstanding political risks that remain a challenge, the narrative will begin to change over the coming months as growth expectations improve. This should provide support to risk assets in the eurozone across both equity and bond markets.

Martin Harvey , March 2015

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