European Equity Barometer – Q4 2014

Macro – Europe’s recovery has weakened, but the ECB stands ready to act

On balance, the weakening of recovery in Europe has been the dominant factor in recent months, over and above the influence of an increasingly aggressive ECB. This has exacerbated the problems faced by Europe’s cyclical businesses following a difficult second quarter.

At a headline level, measures of business confidence in Europe have declined over the last few months, but they remain in expansionary territory. The latest Purchasing Manager’s Index (PMI) for the eurozone was 50.7 (as at end September); within this, Ireland (over 57) and Spain (over 52) have shown the most strength, Germany remains solid but France and Italy have weakened. France has proven to be a particular area of concern, and it remains apparent that significant reform will be needed to become competitive. Italy has crept into technical recession but is going through a period of reform and is in a more stable situation politically with Matteo Renzi at the helm: his recent reform of the senate is a first but important step to addressing the long-lasting stagnation of the Italian economy. The UK continues to impress in its economic recovery: recent IMF forecasts suggest that its growth is likely to outstrip any other G7 nation over the next year.

Inflation has been a key concern in the eurozone in recent quarters. Eurozone CPI is now tracking at 0.4% – a lower rate than any other developed market and less than was expected earlier in the year. A number of factors have influenced this over the past 12-18 months, including the strength of the euro, a decline in soft commodities, wage declines as economies re-adjust, and a lack of underlying demand. Following September’s council meeting, we now have a clear strategy in play to prevent deflation: negative deposit rates intended to increase loan supply, targeted Long-Term Refinancing Operations (LTROs) incentivising banks to channel liquidity to the real economy and asset-backed security purchases to free up capital and stimulate lending.

Despite the extent of these measures, the ECB is ‘not finished yet’ and we believe that Draghi has effectively underwritten the risk of deflation in Europe. The latest credit surveys suggest that demand is improving across Europe among both corporates and consumers, providing some confidence that this policy action can be transmitted into the real economy. Although the take-up of the first LTRO was less than expected, we believe that greater demand will be expressed in the second round after the ECB’s Asset Quality Review and stress tests process, when banks will have more certainty over their capital positions.

In summary, the outlook for underlying growth in Europe has slightly deteriorated in the last quarter, but we retain our view that the European recovery is intact. Recent policy measures announced by the ECB are due to come into force before Christmas and, with evidence suggesting that loan demand is improving, this can have a very positive impact on the outlook for Europe. As one of our portfolio managers recently commented, we remain in a bull market for Europe, but it’s the least fun bull market in recent history.