by It’s hard to pick up a newspaper these days without reading yet another story about yet another crisis somewhere in Europe, whether it’s tensions between Ukraine and Russia, the recurring threat of Grexit, banking sector stress, or political uncertainty in Portugal and Spain. Those are the headlines. Remarkably, none has come close to derailing the ongoing regional economic recovery that’s now well into its third year. Even after the Brexit vote shocked financial markets, cyclical indicators such as the purchasing managers index held steady. Economists on Credit Suisse’s Global Markets team attribute the unshakeable nature of the recovery to its roots in strengthening domestic demand—and for the time being, that bodes well for European equities. For the last two years, falling oil prices and improving labor market conditions helped buoy European household spending. Now that oil prices have stabilized, cheap energy is contributing less than it once did to domestic demand growth, but employment trends are still going strong. While unemployment is still relatively high in the euro area at 10.1 percent, it’s been on a steady downward march since hitting 12.1 percent in June 2013. Meanwhile, auto and retail sales have been growing at a healthy pace of 2.9 percent a year, and domestic demand has risen as a share of overall demand since the end of the region’s recession in 2013.
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It’s hard to pick up a newspaper these days without reading yet another story about yet another crisis somewhere in Europe, whether it’s tensions between Ukraine and Russia, the recurring threat of Grexit, banking sector stress, or political uncertainty in Portugal and Spain. Those are the headlines. Remarkably, none has come close to derailing the ongoing regional economic recovery that’s now well into its third year. Even after the Brexit vote shocked financial markets, cyclical indicators such as the purchasing managers index held steady. Economists on Credit Suisse’s Global Markets team attribute the unshakeable nature of the recovery to its roots in strengthening domestic demand—and for the time being, that bodes well for European equities.
For the last two years, falling oil prices and improving labor market conditions helped buoy European household spending. Now that oil prices have stabilized, cheap energy is contributing less than it once did to domestic demand growth, but employment trends are still going strong. While unemployment is still relatively high in the euro area at 10.1 percent, it’s been on a steady downward march since hitting 12.1 percent in June 2013. Meanwhile, auto and retail sales have been growing at a healthy pace of 2.9 percent a year, and domestic demand has risen as a share of overall demand since the end of the region’s recession in 2013. More recently, Europe’s reliance on exports has declined over the past year—a good thing for any economy in a world of sluggish growth.
Most indicators point to favorable conditions for European firms. Financial conditions are getting easier for both corporations and households, with lending rates falling and loan volumes picking up. The European Central Bank’s March 2016 announcement that it would start buying corporate bonds prompted a flurry of new bond issuance. At the same time, capacity utilization is running high at 82 percent, an indication that business investment will likely increase going forward. That should lend further staying power to the economic recovery. The improving employment situation also bodes well for bank balance sheets, as Credit Suisse’s economists note an inverse historical relationship between rising employment and non-performing loan ratios.
Investors, however, seem to be misreading the tea leaves, and have of late been selling European stocks in droves. Year-to-date outflows as a proportion of assets under management are at their highest level in a decade. Given the pessimistic mood, the market-implied rate of GDP growth in the Eurozone currently stands at zero, but Credit Suisse believes the European economy will actually grow 1.5 percent in 2017.
Another reason for optimism? European companies are more exposed to emerging markets than either Japanese or American firms, with developing countries accounting for one-fourth of European sales and 11 percent of Eurozone GDP. That hasn’t been an advantage in recent years, as the steep decline in commodity prices and sluggish global growth sent many emerging markets reeling, but it will be going forward. Currencies in the developing world are stabilizing, and growth is accelerating. So Euro zone stocks are worth a look. And here is what you’ll find: European stocks are much cheaper than U.S. equities, trading on a 19 percent discount on a 12-month forward price-to-earnings discount, or 7 percent after adjusting for sector differences. Continental Europe is one of only two regions in which the Global Markets equity strategists recommend an overweight position.
Where’s the hitch? The first question mark is the euro: While European exporters benefitted from a major depreciation in the euro in 2014, the positive effects of that depreciation are fading, and Credit Suisse believes the currency will hold steady in the coming months. Second, even though the region has been impressively stoic in the face of recent political upheavals, there is still more to come, starting with an Italian constitutional referendum in November and elections in France and Germany next year.
Finally, the European market is uniquely vulnerable to disruptive forces such as the sharing economy, with an overabundance of easily disrupted companies and not enough disruptors. The equity strategists on Credit Suisse’s Global Markets team note that internet-related stocks account for just 0.2 percent of European market capitalization, compared to 7 percent in the United States. On balance, however, the Bank says there is scope for further “modest outperformance” in European stocks.
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