Political uncertainty and softer economic data have weighed on investor sentiment towards European risk assets. From March to May, outflows from European equity ETFs reached about USD 10.7bn, the largest redemption in any three-month period since 2008, according to Citigroup data. Since a peak in February, the euro has fallen 6.6% against the USD, and 10-year Bund yields have dropped from 80 basis points to 40bps, even though German headline inflation hit 2.2% last month.
But, while political uncertainty has abated with the formation of new governments in Italy and Spain, we expect volatility to persist, and it may be too early to re-enter the market:
- We have a positive longer-term view on the euro, targeting EURUSD 1.30 over 12 months. However, four conditions need to be met before EURUSD can resume a stable appreciation path: first, greater political clarity in Italy; second, more robust economic data; third, the European Central Bank needs to confirm its intention to unwind its quantitative easing program; finally, it is important that US bond yields stay within recent ranges.
- Political uncertainty has pushed some investors into Bunds, but ongoing ECB QE, and the scarcity of Bunds that it has helped to create, have also weighed on yields. Until the ECB gives greater clarity on its plans to end QE, yields will likely struggle to move sharply higher.
- Eurozone corporate profit growth is healthy but not stellar: we expect earnings per share for MSCI EMU to grow by 9–11% this year. The Citi European Economic Surprise Index has stabilized after dropping sharply this year, but has yet to pick up materially. Over the balance of the year, we expect solid global growth to support Eurozone exports.
So while easing political tensions may tempt investors to be more risk-on in Europe, in our view, the fundamentals need to more supportive before the timing is right.
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