Eurozone: Five reasons to change the tune [Quarterly Perspectives] - J.P. Morgan Asset Management

Eurozone: Five reasons to change the tune [Quarterly Perspectives]

Contributor Global Markets Insights Strategy Team

The level of market and media pessimism toward the eurozone increased over the latter half of 2014, as economic momentum stuttered and fears grew of another recession. Meanwhile the dramatic fall in the global price for crude oil further weighed on inflation expectations and heightened fears of outright deflation. These factors all pose important risks to the eurozone economy in 2015, but we see five reasons to believe that the tune for investors in European markets in 2015 might be more upbeat than the one that has been playing in the latter part of 2014.

Less austerity

The eurozone was subject to three years of government belt tightening between 2010 and 2013 as politicians at the national and supranational level imposed a regime of spending cuts to tackle rising deficits and debt levels. Fiscal policy is not going to be very stimulative in the next few years, but the International Monetary Fund estimates that in the 2013 to 2016 period, the level of fiscal tightening in the eurozone will be a fraction of what it was in the past.

Slow, but steady, reform

A pro-growth stance requires significant policy reform at the national level to tackle longstanding rigidities and barriers to growth. The reform process in the eurozone has been hampered by the political environment, but countries such as Spain are now starting to see the benefits of several years’ difficult structural reforms, with private investment on the rise and levels of employment improving. There are also encouraging signs in Italy, where prime minister Matteo Renzi is attempting to remove some of the most restrictive labour market laws and make the electoral process more conducive to further reforms. Meanwhile, reforms in Spain are beginning to translate into higher growth rates. In short, progress is slow, but it is in the right direction.

A potential turn in the credit cycle

So far, the eurozone recovery has been devoid of credit growth, as banks have shrunk their balance sheets and deleveraged. A tighter regulatory environment forced banks to improve capital ratios while the Asset Quality Review (AQR) and associated stress tests caused banks to jettison anything that could be perceived as risky and restrict lending practices. However, now that the AQR is complete, that burden has been lifted from banks, and while lending may not skyrocket, we would expect to see a modest uptick in corporate lending. We see early signs of this in the European Central Bank’s (ECB’s) latest bank lending survey, which shows that not only are banks making it easier to access bank lending, but that demand for loans from both households and businesses is on the rise.

A central bank willing to act

From “whatever it takes” to “all that we must”, ECB president Mario Draghi has been resolute in his commitment to restore both inflation and growth in the eurozone. Though the ECB’s governing council does not always line up behind Draghi, it has been willing publicly to endorse the goal of expanding its balance sheet by €1 trillion. Draghi has confirmed that the ECB is already making preparations for further easing measures to achieve that goal, such as the purchase of non-financial corporate or even sovereign bonds, should it be needed. This is now widely expected to happen in the first part of 2015.


A weaker euro

In effect, the ECB’s drive to increase the size of its balance sheet is an attempt to force the value of the euro lower. During 2014, the euro depreciated by 12% against the dollar and is expected to decline further as the ECB chases the €3 trillion target for its balance sheet. A weaker euro increases the costs of imports, offsetting some of the dis-inflationary pressures from weaker internal demand, and a falling oil price. However, a falling euro benefits companies because half of European company revenues come from outside of Europe and the currency effect should start to appear as higher profits.


Investment Implications

  • 2015 could be a rewarding year for investors in European assets, thanks to less austerity, steady economic reforms, a turn in the credit cycle, a more pro-active central bank and a falling euro.
  • European equities are not cheap, but nor are they especially expensive.
  • The eurozone economy is unlikely to see a rapid upturn in growth in 2015, but sentiment has turned so far against European equities that they should be well positioned to deliver for investors.



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