After five years of stagnation, European corporate earnings per share (EPS) should grow strongly this year. Consensus estimates look reasonable, with 2017e EPS in the Eurozone rising by 11%. When profits are up, as a rule so are markets. As for political risk, European investors do not seem worried. Experience in recent years has shown them that politics rarely impacts markets beyond a very short investment horizon. We think the latest political developments in Europe are unlikely to have severe economic consequences.
The most probable scenario is prolonged political tension without a breakthrough in any direction, in our view. Markets seem to have already priced this risk, so we do not expect further downside to Spanish and Eurozone equities. We think the main risk is not a form of structural independence but social unrest that could hinder economic activity, a scenario to which we attach a low (10–20%) probability.
The political and economic environment in Italy has improved markedly since the beginning of the year. The country’s leading populist parties, the Five Star Movement and the Northern League, moderated their rhetoric and are no longer calling for a referendum on Italy’s euro membership ahead of the election in early 2018. We think the Italian economy is on track to grow at a rate of 1.5% this year, substantially higher than initially forecasted. Italian banks are also better capitalized and their inventory of non-performing loans has been reduced in the past few years.
The lack of progress so far on UK's exit negotiations with the EU draws attention to December's European Council meeting. We expect talks to be moved to phase two (transition and trade) at this meeting, while any delay could dampen sentiment towards the UK and cause sterling assets to slide. Without progress on a transition deal before March 2018, companies based in the UK that operate in the EU will have to exercise contingency plans for a no-deal scenario, weighing further on the already sluggish UK economy. The impact on the European Union, however, will likely be limited.
In sum, the current state of the European Union seems to reflect the broader state of the global economy, where a strong and synchronized uptick in global growth and strong corporate earnings in major regions make us positive on equities. As for the heightened political risk, markets seem to have grown accustomed to headlines. Be it the Catalan referendum, the UK exit negotiations or North Korean aggression, asset classes have remained resilient, supported by upbeat economic activity worldwide.