The Outlook: July 2020 economic commentary

Reasons for cautious optimism in the eurozone

From an economic and market perspective, the eurozone has arguably been something of a disappointment in recent years. The performance of both its economy and equity markets has trailed that of other regions, most notably the US. The structural flaws of the currency bloc have meant that the potential for an existential crisis is never far away, while fiscal conservatism has resulted in an overreliance on European Central Bank (ECB) activism during times of economic weakness.

Nevertheless, there are signs that things are changing for the better, in large part due to a shift in stance from the German government of chancellor Angela Merkel. In recent weeks, Berlin has announced a big deficit-financed fiscal stimulus as well as supporting a pan-EU recovery fund financed by jointly-issued debt – two developments which prior to the coronavirus outbreak would have seemed unthinkable. 

From (black) zero to hero

The announcement in June of a package of measures designed to stimulate demand worth nearly 4% of GDP marks a dramatic shift following years of adherence to the so-called “schwarze Null” (“black zero”) policy of balancing the budget. Coming on top of earlier emergency measures to cushion the economy from the pandemic, the overall German fiscal stimulus is now set to become one of the biggest in the world. These measures, including a temporary VAT cut, funding for green technologies and investment incentives, may give rise to the possibility of a marked improvement in domestic demand going forward.

From a longer-term perspective, however, Germany’s support for a Euro 750bn EU recovery fund is potentially even more significant. Details are yet to be agreed, but as it stands the plan includes Euro 500bn in grants and Euro 250bn of favourable loans which will be distributed to EU member states hardest hit by the coronavirus crisis. Opposition from the so-called “frugal four” – Holland, Denmark, Austria and Sweden – suggests the plan could ultimately be watered down when it is discussed at the EU summit due to take place on 17-18 July. However, with Germany, France and other EU member states in favour of the plan, it seems likely that it will eventually be given the go-ahead without major changes.

Such a pan-EU fiscal expansion should improve future growth prospects; the European Commission anticipates that it could lift the EU’s GDP by 1.5-2.25% by 2024. Moreover, investment in new technologies and training could also boost the region’s potential long-term growth rate.

However, even greater significance comes in Germany’s apparent acceptance of the need for unconditional fiscal transfers from wealthy member states to crisis-hit regions to avoid economic divergence and maintain cohesion within the eurozone. Although the initiative is deemed temporary, this potentially opens the door to further pan-EU stimulus funded by pooled liabilities in the event of future crises. As a result, the region is on the brink of taking a small step towards the increased fiscal integration that many observers see as crucial for the sustainability of the single currency bloc.

Although a full-blown fiscal union remains a distant prospect, a perceived reduction in the risk of a breakup in the eurozone could enhance the long-term attractiveness of the region’s financial assets. . A disintegration of the currency bloc has been a recurring concern of fund managers over the past 10 years; establishing a process towards greater intra-EU burden-sharing might ease such worries.

Post-lockdown recovery

In the short-term, the trajectory of the economy will hinge crucially on developments regarding coronavirus.

On this front, the eurozone has also been a source of good news recently. In contrast to the US, where record increases in new coronavirus cases have been witnessed in recent weeks, the new infection rate in continental Europe has slowed to a fraction of the peak seen in early April. Given that elevated infection rates threaten to weigh on consumer confidence and hamper progress towards a normalisation of economic activity, continental Europe’s relative success in containing the virus has raised hopes that growth could outperform the US during the second half of the year.

Cheerleaders for the region also note that it is well placed to benefit from a post-lockdown global upswing. In particular, German exporters should benefit from the V-shaped recovery that is currently being seen in the Chinese economy.

Whether these positive factors usher in a period of outperformance for eurozone equities is open to debate. The region’s underperformance over the last five years, with the iShares MSCI EMU ETF being up around 11% over the period versus a 44% rise in the iShares MSCI World ETF and a 42% gain in the iShares MSCI USA ETF, has in large part been due to the sectoral composition of its markets. While US markets have been propelled higher by fast-growing tech giants (Amazon, Apple, Microsoft, Facebook and Google), eurozone equity markets have a greater exposure to so-called ‘old economy’ sectors such as financial services and automotive, which have lagged by comparison.

The eurozone’s banks have been a notable source of weakness. Negative interest rates and a flat yield curve (i.e. the gap between short and long-term interest rates) have been a drag on the sector, and there is little prospect of these headwinds abating soon.

Nevertheless, after years of lacklustre performance, a significant valuation gap has opened up. According to data from JP Morgan, the cyclically-adjusted price earnings ratio for the eurozone stands at 18.6 versus a reading of 30.0 for the US. On a sector neutral basis, the eurozone price earnings ratio is trading close to an 8-year low versus the US. Moreover, compared to the negative yields available on most government bonds in Europe, a dividend yield of 2.3% looks relatively attractive.

All of this suggests that there is scope for investors, who have generally shunned eurozone equities in recent years, to take a somewhat more positive view of the region. With the economy having experienced several “false dawns” in the past, a degree of wariness is warranted, but recent developments provide grounds for cautious optimism.

16 July 2020

This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.