The cover of the October 25 edition of The Economist depicts the Eurozone economy in the form of a parrot, lying on its back receiving fluid from an intravenous bottle with a euro insignia, and to the side Germany’s Angela Merkel saying “It is only resting…” Is the recent obvious pause in the gradual recovery of the Eurozone economy nearing an end, to be followed by a return to modest but sustained growth, or is the area headed for another recession? In recent months investors’ views towards Europe turned negative, contributing to a global correction in equity markets; but European and global stocks have been recovering since mid-October. Have we seen this year’s lows for Eurozone stocks, or is more selling to come?
There are reasons to be optimistic, but significant risks remain.
Who Can Forget The Reductions?
The more negative views of investors on growth prospects for the Eurozone were supported by the IMF’s reductions in its forecasts for the region’s real GDP growth, to 0.8% in 2014 versus 1.1% in their July projections and to 1.3% in 2015, versus 1.5% formerly. For the largest Eurozone economy, Germany, the IMF now projects 1.4% for 2014 and 1.5%, versus 1.9% and 1.7% formerly. Similar reductions were made in the projections for Italy and France, while the estimates for Spain were raised slightly to 1.3 % and 1.7%. Our projections are very close to these. They do not imply a return to recession but rather a very gradual quickening of the pace of the region’s economies. The economic outlook for some of the Northern European economies is brighter. Ireland looks likely to achieve a 4.8% growth this year, moderating to 3.2% in 2015. The UK economy should grow by 3.1% this year and 2.8% in 2015. And the outlook for Sweden is improving, from 2.2% this year to 2.4% in 2015.
The downgrading of Eurozone growth projections reflects some negative current activity data for Germany, France, and Italy, while activity in Spain appears to have strengthened. Business confidence has weakened, probably affected by geopolitical tensions related to the unresolved situation in Ukraine and the threat from ISIS. There are also increased doubts that the European Central Bank will be able to do more to help the recovery. The German IFO business climate survey fell in October and was weaker than most expected. However, the European Commission reported an unexpected increase for October in the Eurozone economic confidence index to 100.7 from 99.9 last month.
Concerns about the risks of deflation in Europe also concerned investors. Eurozone core consumer price index growth for September was 0.8%, down from 0.9% in August. Nine countries experienced core inflation below 1%. Headline inflation was only 0.3%, down from 0.4% in August. The ECB continues to state that it believes deflation will be avoided for the Eurozone as a whole. We also expect that the low point in inflation has been reached and that the depreciation of the euro will contribute to very modest increases in inflation in the coming quarters. Deflation does remain a threat. This may lead the ECB to expand its quantitative easing efforts, but there are practical and legal constraints to this.
Then Again...
There have been some positive developments, however. The Flash Purchasing Managers’ Index, PMI, for the Eurozone increased in October. The consensus was for a small decline. The Flash PMI for Germany also edged up, while that for France declined, widening a gap between the manufacturing prospects of the two markets. Another positive development that has been limiting the effects of slower economic growth on stock prices is continued decent earnings performance. Over 70% of European companies reported positive earnings growth in the third quarter.
The report last weekend of the ECB stress tests for the 103 largest banks in the Eurozone was another positive, even though some felt the tests were not stringent enough. To understand the importance of this development, recall that in Europe, banks are responsible for financing some 80% of the economy, in sharp contrast to the US, where just 20% of the economy relies on bank financing. Twenty-five banks failed the tests, and of these, just 13 still need to raise a total of 10 billion euros ($12.65 billion) in additional capital. The other 12 have already corrected their shortfalls. Among the 13 banks still with shortfalls, Italy accounts for four; Greece and Slovenia each have two; and Ireland, Belgium, Austria, Cyprus, and Portugal each have one. The broad picture should reassure those who feared there were significant holes in the balance sheets of the Eurozone’s banks. The problem areas were concentrated in markets hardest hit by the financial crisis. The process is a positive step towards the ECB’s taking on the supervisory role of European bank regulator. It was a huge undertaking to review the underperforming loans in some 800 portfolios.
EU Banking
There may be some easing in the cost of raising capital for banks that did well in the tests. The tests showed that Spain has cleaned up its banking system, while Italy’s banking system was shown to be fragile. It had a total of nine banks that failed the tests, of which five have subsequently made up their shortfalls. It is hoped that Eurozone banks will now be a little more willing to ease credit conditions, particularly those banks that have been hoarding capital awaiting the results of the tests. Higher growth in lending will require, however, increased demand for loans on the part of businesses and consumers.
Investing in Eurozone equity markets has been a losing proposition this year. The year-to-date performance of the iShares MSCI EMU (Eurozone) ETF, (NYSE:EZU), is -10%. Germany’s equity market has fared even worse. The iShares MSCI Germany ETF, (ARCA:EWG), is down 15.1% thus far this year. The substantial euro depreciation accounts for much of the reduction in US dollar returns on these ETFs. This is evident when one sees that the WisdomTree Europe Hedged Equity Fund ETF, (NYSE:HEDJ), which contains a hedge that removes the effects of changes in the euro/US dollar exchange rate, is down only -1.97% year-to-date.
The market correction since June has left Eurozone equities highly oversold; and valuations in Germany, France, Italy, and Spain are all well below their 10-year averages. The steep mid-year correction looks to us to have been excessive. With the pace of economic activity likely to get a bit stronger in coming quarters, helped by strong growth in the globe’s largest economy, that of the US, and a tailwind from euro depreciation, we expect the very recent modest recovery in Eurozone equities to continue into 2015. We have increased our allocation to the Eurozone in our International and Global ETF portfolios. As we expect the US dollar to continue to strengthen versus the euro, we are continuing to use the hedged ETF, HEDJ.
Bill Witherell, Chief Global Economist