Macro Monthly Spring in Europe

Eurozone contributions to annual GDP growth

Pick-up in China trade suggests a rebound in European manufacturing

The largest contributor to Eurozone domestic growth, household consumption, also dipped somewhat last year amid political uncertainty. However, the primary driver of consumption, household income growth, remains solid. Indeed last year's softening in spending may have been just a temporary phenomenon as consumer sentiment started to tick up again in Q1 while labor and wage dynamics remain supportive of consumption.

In the previous Macro Monthly, we illustrated the improved fiscal impulse for the Eurozone but it is worth reiterating the positive impact on government expenditures and economic growth for 2019. This month the IMF revised their fiscal effort estimate for the region and the primary structural deficit more than doubled from late 2018 estimates and resides at levels not seen for almost a decade. A primary structural deficit contributes positively to GDP growth.

Eurozone primary structural balance (% of trend GDP)

Despite domestic and external uncertainties, we are encouraged that European business investment has been quite resilient. According to a recent survey conducted by our UBS Investment Bank colleagues, capex intentions remain elevated with cash layouts further increasing in 2019. This is an encouraging sign for productivity, wages and ultimately potential growth—ultimately extending the business cycle.

Lastly, the ECB will stay on hold for a prolonged period of time with Eurozone harmonized index of consumer prices (HICP) inflation still muted. This in conjunction with further new measures such as a potentially more stimulative targeted longer-term refinancing operation (TLTRO) for banks or the introduction of a tiering system for excess reserves should help European banks and loan growth.

Political Risks

European parliamentary elections

There is a confluence of local political overhangs in Europe but in our view these risks are manageable and well-reflected in market pricing. The 2019 European Parliament elections taking place in late May are in focus given expectations for a rise in anti-establishment parties¹ which are projected to win close to 30% of the seats (see Exhibit 4). Receiving less coverage is the growth of pro-EU integration parties such as the Alliance of Liberals and Democrats for Europe (ALDE). While parties forming the current coalition (European People's Party (EPP) and Social Democrats) will lose out to these new alternative parties, they will remain a sizeable force and require a third group to build a coalition. This is much more likely to be a pro-integration party which could tilt the reform agenda into the direction of increased risk sharing and fiscal integration over the coming years. Indeed, it will prove difficult for the anti-establishment parties to build a coalition necessary to obstruct reform, given significant differences in ideology (right and left) on most issues.

Current coalition of EPP and Social Democrats will require a third group, most likely to be pro-integration

Italy

The fragile Italian coalition between the far-right League and far-left five Star Movement could be tested after the EU parliamentary elections. A strong performance by the League may embolden its leader Salvini to call fresh Italian elections, sparking renewed uncertainty and volatility. But a new election could ultimately result in a rightwing coalition without the five Star Movement and ultimately proves more business friendly. Rating agencies have confirmed Italy's credit rating two notches above non-investment grade, Italian bond yields have declined and the banking system is gradually healing. While Italy experienced a mild recession in H2 2018, the economy is showing early signs of recovery which should help stabilize the debt trajectory. While there are plenty of long-term structural concerns in Italy in the near term we believe that the country's problems do not pose a threat to the construct of the Eurozone.

Brexit

With the UK and Europe kicking the can on Brexit to a new October 31 deadline, immediate pressure has eased. But the overall risk of a no-deal Brexit seems to have declined. The results of indicative votes in Parliament show a no-deal Brexit as the least desired of all potential options. Indeed, even a revocation of Article 50 (the trigger for Brexit) received a stronger backing than the no-deal option. In an emergency, the UK Parliament could – according to a ruling by the European Court of Justice - unilaterally revoke the exit procedure at the last minute. While uncertainty about the final deal remains, the tail risk of an economically damaging crash out looks remote. 

US-EU trade negotiations

The key external risk to Europe is an escalation of trade tensions between the U.S. and EU. It is clear that as soon as the US and China come to a trade agreement, the Trump administration will turn its sights to Europe. Indeed, the Trump administration has until May 18th to decide if it would like to press ahead with tariffs on autos and auto parts under its Section 232 investigation into national security risks. We do expect volatility around this announcement and it is quite possible the administration will announce an 'intention' to tariff some form of autos or auto technologies. However, we suspect this is a tactic to create leverage in more comprehensive trade negotiations between the US and EU over coming months, and that actual tariff implementation will be watered down, delayed or not happen at all. As we approach the 2020 elections, President Trump is likely to be more careful in how he proceeds with trade policy given that he evidently sees economic and market performance as key to his political prospects. As trade uncertainty contributed to the market downturn in Q4, President Trump will likely have to tread carefully on this issue. Moreover, there is little business, public or congressional support for auto tariffs. In the end we suspect that amid scattered headlines and threats, the ultimate actions taken will pale in comparison to the US-China trade war which escalated last year. In the end, we do not see sustained negative market or economic damage from auto tariffs.

Valuations

Exhibit 5 shows that the EU valuation discount to global equities (ex-Japan, which is also cheap) is near 30-year lows. In April, the well-followed Bank of America fund manager survey noted short European equities as the most crowded trade for the second month in a row. We suspect that the bar is low for European risk assets, and as confirmation of growth stabilization in Europe materializes, EMU stocks can rebound quickly. Meanwhile, European bonds appear excessively priced even considering ongoing structural trend growth headwinds and negative rates. Markets have essentially priced in that the ECB will not be able to normalize rates this cycle. But if we are right on economic stabilization and with a new ECB President due to replace Draghi later this year, we think there is room for some healthy repricing of bunds. In FX, the EURUSD is somewhat cheap and we would expect the exchange rate to react positively to an improvement in the global growth picture.

Valuation discount vs. global equities (ex-Japan)2 based on forward P/E and PIB multiples

²Japanese equities are excluded because prior to the introduction of key market reforms around the turn of the century, Japanese accounting and auditing standards significantly deviated from other markets, which distorts relative valuations.

The bottom line: Asset allocation

Manageable political risks and the improving trade environment creates room for a catch up in European stocks relative to some of their global peers. Across Investment Solutions portfolios, we are slightly overweight a diversified basket of European banks, small caps and Italian equities assuming a constructive stance on domestic Europe. Furthermore, we like the chances for European equities to perform well in the second half of 2019 supported by their higher cyclicality, greater exposure to international trade and steeper valuation discount. We remain of the view that European yields and the EUR are set to rise as the European economy rebounds over coming months.

¹ We excluded Japanese equities because prior to the introduction of key market reforms around the turn of the century, Japanese accounting and auditing standard significantly deviated from other markets and distort relative valuations.

Asset class attractiveness

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness, as well as the relative attractiveness within equities, fixed income and currencies, as of April 26, 2019.