Don’t worry about the near-term moderation
Eurozone economic surprises have fallen rapidly and the period of growth surprises may be behind us.
Even so, the Eurozone economy remains in close to its best shape for a decade, boosted by a strong domestic recovery and still accommodative monetary policy.
Although the economic surprise index has dropped sharply, unlike in 2011-12 when there was a euro debt crisis, there is no fundamental reason for worry this time round.
Some weakness can be attributed to the weather, but importantly, a lot has to do with expectations running ahead of reality - Europe’s PMI is unlikely to stay over 60.
Its PMI has fallen to 56.6, which still points to strong growth, but would drive the surprise index lower (See chart below).
Source: Bloomberg, Bank of Singapore
Europe’s rebound has more legs
After years of sub-par growth, Europe’s economic recovery is finally on a solid footing. The recovery is also encouragingly broad-based, with domestic demand as the main driver.
The cycle in Europe is two to three years behind that of the US, which means that there is ample scope for the European economy to expand.
The revival of capex
While domestic demand has been the key growth driver in recent years, there are signs that the return of capital expenditure will become another important growth driver to propel Europe in the years ahead.
After years of under-investment, capex spending is picking up and can continue for several years as companies upgrade and replace their obsolete equipment.
The capex cycle is witnessing both stronger demand and expectations of stronger output, according to business surveys.
As there is less spare capacity, private investment is also likely to expand for the next few years.
European corporates have deleveraged over the last few years and their balance sheets appear healthy.
The level of cash holdings on their balance sheets also remains elevated by historical standard.
European corporates are also raising dividends – another sign of healthier balance sheets.
As much as 83% of European corporates are likely to increase dividends this year, with about 89% of European financials expected to grow their dividends.
Relatively more accommodative policy
Despite these marked improvements in the economy, the European Central Bank (ECB) is maintaining its quantitative easing (QE) programme for now, albeit at a much reduced pace.
Inflation is now moving higher but remains very subdued with core inflation struggling below the ECB’s 2% target due to some slack remaining in the economy and the deflationary effect of a stronger euro.
The ECB has stepped down its QE from €60 billion per month to €30 billion since the start of the year. The ECB has committed to running at this level until September, after which it will probably cut down to €10-15 billion, for three months, ending purchases altogether by the end of this year.
The next step will be to raise interest rates, possibly in the second quarter of 2019.
The ECB will only start to reverse QE or shrink its balance sheet in 2020 and beyond.
Therefore, compared to the US, monetary conditions in Europe will remain much more accommodative and for a longer period of time.
Less political risk
European political risk has subsided dramatically as Eurosceptic parties did not gain power from the crucial elections in France, Germany and the Netherlands last year.
The recent Italian elections also did not throw up any negative surprises.
These favourable electoral outcomes will buy time for Merkel and Macron to push ahead with economic reforms that will further consolidate Europe’s unity.
European equities less affected by technology
For most of last year, Europe underperformed the US largely because of the lower technology exposure (less than 5% of Stoxx Europe 600) in European market indices.
Of late, technology, especially in the US, is under pressure because of data privacy issues.
European market indices with a larger exposure to financial (more than 20% of Stoxx Europe 600) and a lower technology exposure may be shielded from the recent tech weakness and stand to gain as rates continue to grind higher.
From a valuation perspective, European equities are more attractive compared to the US as well as against its own historical average.
European banks in better shape
European banks are now in better shape to ride on Europe’s recovery.
Over the past few years, the health of European banks has improved dramatically.
The recovery process was not easy - European banks’ balance sheets were strengthened through a series of capital raisings and credit write-offs.
As a result, European banks have managed to reduce their leverage and improved their capital position.
At the same time, credit growth continues to improve which could lead to a re-rating of European banks.
Thus, European banks are now better poised to improve shareholder returns in the years to come.
A couple of years ago, the Italian banking system was in distress - Banca Monte Paschi di Siena had to be recapitalised by the Italian government.
Today, the Italian banking system is improving with non-performing loans (NPLs) starting to ease.
The valuations of European banks continue to look attractive.
Beyond banks, the European insurance sector is looking as attractive as a defensive sector that has positive earnings momentum and benefits from higher yields.
Gain European domestic exposure
One of the headwinds facing Europe is the stronger Euro.
Our currency strategist forecast the EUR/USD to appreciate to 1.29 over 12 months.
This appreciation of the Euro against the US dollar should not derail European equities.
This is because the Euro on a trade-weighted basis is still fairly stable and European corporations have diversified sales exposure globally, with sales to the US at less than 20%.
Taking into account a stronger euro, we prefer European companies with domestic exposure as they will be better insulated from a stronger euro and at the same time, shielded from the negative spillovers of trade tensions.
Opportunities in European banks and domestic plays Europe’s economic and corporate earnings outlook remains solid but the positive momentum is starting to be challenged.
While we expect a choppier ride for risky assets, valuations especially for European equities are starting to look attractive.
In terms of asset allocation, we maintain an overweight position in European equities.
Within Europe, we have a preference for European financials and European domestic plays.
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