What investors can learn from the European economy in 2017

Strong performance despite political uncertainty

12 Dec 2017

11 Dec 2017

The EuroStoxx is up around 15% this year, while the German DAX reached an all-time high this month. Volatility, as measured by the VDAX – a gauge of market risk perception – is close to historical lows. Spreads on European peripheral government bonds and on European high yield credit are at or close to post-financial crisis lows as well.

At a first glance, this may seem surprising in the wake of recurring political uncertainty in several European countries. However, a closer look at the European market and its drivers lends an explanation. In general, both the European economy and European equities are highly receptive to the global business cycle. In other words, Europe has always tended to do well when the world did well, and vice versa – despite some occasional domestic issues.

Just as Europe resonates with the world in terms of economic growth and market performance, in 2017 it also mirrored the global environment of heightened political risk. What lessons can we learn about the workings of global markets by looking at Europe more closely?

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Economics

European growth has been much stronger than consensus expected this year. The Eurozone is now set to record a real GDP growth of around 2.3% for 2017 according to our forecast, the first time since 2010 that the rate will exceed 2%. European assets reacted very positively to this news, suggesting that macroeconomics is indeed a more important driver for markets than politics.

Europe's wave of recovery

Real GDP growth, in % year-on-year

Source: UBS, as of 8 November 2017

Corporate fundamentals

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.

Catalonia

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.

Italy

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.

United Kingdom

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.

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