MACRO AND MARKET PERSPECTIVES

A renewed spring in Europe's step

Apr 17, 2019

We expect Europe to shake off its current soft patch later this year, getting a boost from China’s stimulus efforts and any resulting rebound in global manufacturing. If the global growth backdrop improves and one-off setbacks subside, solid domestic demand should drive the recovery.

The recovery

Europe is still holding back global growth, having been a key support in prior years. Yet much of the eurozone weakness can be attributed to the fading support from export demand as world trade nosedived. As the most open G3 economy, Europe suffered more greatly.

In the coming months, we expect Europe to gradually move out of its tricky spot provided that the UK’s dragged-out Brexit debate doesn’t morph into a disruptive exit and rising US-EU trade tensions don’t shock confidence. The US slapping tariffs on European products – whether autos or other – should have only a moderate direct economic impact. Unless it sparks a broader confidence shock, this shouldn’t disrupt the solid domestic cyclical dynamic. And so we expect the upbeat domestic trend to reassert itself once global trade starts to normalise and idiosyncratic setbacks (auto production) and sector bottlenecks fade.BlackRock Eurozone Growth GPS vs. BlackRock Eurozone FCI, 2015-2019

Sources: BlackRock Investment Institute, with data from Bloomberg, April 2019. Notes: The GPS in green shows where the 12-month consensus forecast may stand in three months’ time for the eurozone. The orange line shows the rate of GDP growth implied by our financial conditions indicator (FCI), based on its historical relationship with our Growth GPS. The FCI is moved forward six months, as it has historically led changes in the Growth GPS. Forward-looking estimates may not come to pass.

Eurozone growth is supported by accommodative monetary policy, a more expansionary fiscal policy stance, higher than normal capacity utilisation rates and labour markets approaching full employment. Our financial conditions indicator (FCI) shows that eurozone conditions have eased significantly in the first part of 2019 – an improvement that is on par with the one seen in early 2016. For that reason, we expect GDP growth to pick up and move slightly above trend levels (around 1.25%) in the second half of this year.

What underpins our call for a recovery? A rebound in the FCI, Chinese stimulus and fading headwinds. Half of the nearly 80 eurozone activity indicators, summarised in our eurozone Growth GPS nowcast, are starting to show meaningful improvement. We arrive at this supportive evidence via a months-to-cyclical dominance (MCD) approach – a method of seeing whether a variety of data series can help confirm a cyclical shift in the economy on the upside or downside.

Industrial data for the start of the year are still poor. Germany – where factory orders plunged in February – remains the weakest link. But other data – especially for the services sector – are holding up or starting to recover. And incoming information on near-term growth tentatively suggests building momentum at the start of the second quarter. Our eurozone Growth GPS started to stabilise in mid-March, indicating that the consensus forecasts for eurozone GDP over the next 12 months are close to bottoming out. The GDP forecast downgrades that began at the start of 2018 may have nearly run their course. Historically, our GPS signal has led consensus forecasts by about three months (see our interactive macro dashboard for more detail). This suggests that investors still have some time to position themselves for potential forecast upgrades.

 

Problematic politics

We expect eurozone growth to pick up in the second half of this year. But the risks around our favourable base case are considerable – and they are mainly tied to potential political troubles.

The UK has bought more time to hammer out a Brexit agreement, but uncertainty remains. There may be renewed escalation of the trade tensions between the US and EU, centred around car tariffs. US President Donald Trump has until May 18 to decide whether to take action against European car producers on national security grounds. And European Parliament elections in late May could result in a populist sweep of protest parties from both ends of the political spectrum. This would further erode the influence of pro-European centrist political forces.

Heightened concerns about Europe’s future would likely lead to a renewed widening in peripheral eurozone government bond spreads. The 2020 budget season may refocus attention on the conflict between the Italian government and the European Commission. There are also going to be leadership changes this year in many EU Institutions, including at the ECB. The BlackRock Geopolitical Risk Indicator shows that investors are keeping a keen and wary eye on the risk of European fragmentation – it is the most prominent geopolitical concern for financial markets at the moment. It is not surprising that Europe is becoming increasingly under-owned.BlackRock Eurozone Growth GPS vs. BlackRock Eurozone FCI, 2015-2019

Sources: BlackRock Investment Institute, with data from Thomson Reuters, April 2019. Notes: The chart shows the percentage point spread of various 10-year eurozone government bond yields over the German 10-year bund yield.

Assessing the ECB’s options

We believe the ECB should pause further steps towards policy normalisation for the remainder of this year – and likely beyond – to ensure a return of inflation to its below-but-close-to 2% price stability objective. At the upcoming meetings, the Governing Council will set the conditions for further long-term loans to banks (TLTRO3), discuss tiering of reserves and review its monetary stance. While a further extension of forward guidance would likely be the first line of defence, additional policy action is also becoming more likely. The continuation of ultra-accommodative ECB policy is reassuring for near-term growth. But the perceived lack of policy levers to counter any future downturn could rattle markets in the long term.

ECB President Mario Draghi could complete his eight-year term without once tightening policy. It is not clear whether his successor will get an opportunity to raise rates from -0.4% before the next downturn. If the next ECB policy move is to ease, there won’t be many options left in the monetary toolbox. In this situation, the ECB could either lift self-imposed constraints on its government bond purchases – the Public Sector Purchase Program (PSPP) – or move into new asset classes, such as equities or bank bonds, or push market interest rates even lower through rate cuts or forward guidance. Yet all of these options would likely face considerable opposition on the Governing Council.

 

Attractive valuations

We continue to prefer a “barbell” approach to risk taking in the late-cycle stage: quality stocks, income-generating bonds and emerging markets. And there are a number of investments in Europe worth highlighting.

Europe offers attractive asset valuations compared to history, especially in risk assets. Regional assets have cheapened further compared to a year ago as concerns about growth and politics increased. The exception to this are core government bonds, which we believe to be expensive compared to global peers.

As downward revisions to growth start petering out and incoming activity data begin to show signs of life, European risk assets might get a boost this year as value equities benefit. For any equity rally to have legs, investor concerns around a disorderly Brexit, global trade conflicts, European elections and Italian politics have to diminish, in our view. Given how under-owned Europe has become, even a tentative recovery might spark a relief rally.

Our analysis shows that a considerable chunk of the discount in regional assets can be pinned to increased investor concerns on European fragmentation, suggesting that political risks are more adequately priced at the moment. See the Crisis concerns chart. By looking at the eurozone equity market performance more closely and comparing it to moves in inflation-linked government bonds, we find that growth expectations played a limited role in the weak performance over the past year – while political risks played a large part.Contributions to change in European equity prices, 2018-2019

Sources: BlackRock Investment Institute, with data from Thomson Reuters, April 2019. Notes: The chart shows the estimated decomposition of the change in European equity prices into the part driven by growth expectations and the part driven by other factors, including uncertainty.

One investment option in the fixed income space that does not require a growth comeback: long eurozone breakeven inflation rates, now at their lowest levels since 2016. We also continue to see compelling relative value in BBB-rated European corporate debt, even as we maintain a neutral view on European corporate bonds overall.

Another idea is a tactical long euro position against the US dollar. The euro has underperformed other risk assets during the 2019 market rally, in our view. The easier stance adopted by the ECB, ongoing forecast downgrades and worries over US car tariffs and political risk more broadly have weighed on the currency. We see much of this negative news as now reflected in the euro’s price. Yet the increasing use of the euro as a funding currency in carry trades could limit gains. On balance it is therefore unlikely that sustained appreciation of the currency would derail a recovery in the second half, in our view.

 

Jean Boivin
Global Head of Research, BlackRock Investment Institute
Jean Boivin, PhD, Managing Director, is Global Head of Research for the Blackrock Investment Institute and is a member of the EMEA Executive Committee.   His ...
Elga Bartsch
Head of Economic and Markets Research, BlackRock Investment Institute
Elga, Managing Director, heads up economic and markets research at the Blackrock Investment Institute (BII). BII provides connectivity between BlackRock's ...
Head of EMEA Fundamental Fixed Income, BlackRock