Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
Yes. The seemingly ever-expanding US-China trade war has undercut economic activity in the euro area, challenging earnings expectations and the bloc’s currency. Still, we continue to like the euro area as part of a risk-controlled overweight to global ex US equities funded from US equities.
Last month, the United States announced it would increase tariffs to 25% on over one-third of all Chinese exports to the United States, worth roughly $200 billion, prompting China to announce it would increase tariffs to roughly the same level on about $60 billion of US imports. These new policies, which are just the latest in a series of actions, are to be implemented as euro area economic growth has stalled. Activity expanded by only 1.2% in first quarter 2019, according to preliminary year-over-year estimates—less than half the rate of growth the bloc enjoyed one year ago. More concerning is the toll the recent uptick in bellicose rhetoric is having on expectations; analysts have slashed estimates for 2019 euro area economic growth this year by 40 basis points to 1.2%, according to Bloomberg.
The euro area’s high export dependency partly explains the bloc’s slowdown. At the end of 2018, euro area exports accounted for just under 20% of the bloc’s output, higher than the same measure for the United Kingdom (16%), Japan (15%), and the United States (8%). Perhaps surprisingly, China’s exports as a share of its national output are also lower (18%), following years of domestic economic development. The euro area’s dependence on external markets means its economy is vulnerable to changes in global demand. This is particularly true for the euro area’s bellwether, Germany, whose exports represent a staggering 39% of its economy and whose industrial production is closely correlated with global trade flows. 1
The bloc’s present political and policy challenges have amplified the euro area uncertainty generated by the US-China trade war. Recent EU parliamentary elections resulted in the traditional centrist coalition losing its majority, with far-right and left parties gaining ground. This reality, along with the soon-to-be-named successors to the Presidents of the European Council, European Commission, and European Central Bank (ECB), raise the specter of a policy miscue. Should economic activity worsen, the ECB’s limited room to maneuver further complicates these new leaders’ tasks. The ECB’s main refinancing rate is currently set at a record low of 0%, and the bank owns about one-quarter of all existing euro area sovereign debt.
Yet, euro area equities have held up well this year. They have returned 11.0% to investors through the end of May, as compared to developed markets equities’ 10.2%, in local currency terms. 2 Although equity earnings expectations for the bloc’s corporates have fallen since the start of the year (analysts are currently penciling in growth of 5% for 2019, down from 9% at the start of the year), they remain higher than for US equities (3%) and most other major markets. To be sure, a primary reason for the higher expected euro area earnings growth is that earnings results have been lackluster this cycle, meaning their lower base affords more room for growth. These equities, with their expected growth, are also priced reasonably relative to long-term historical trends.
The euro area’s reasonable pricing isn’t unique. In fact, our preference for a risk-controlled overweight to global ex US equities funded from US equities is linked to that very fact. One measure, which compares the gap between US and global ex US cyclically adjusted price-earnings ratios, has rarely been as elevated over the past four decades. Moreover, the historically stretched US corporate profit margins are at risk of reverting back to a more normal level, particularly if the tight US labor market boosts future employee compensation costs. While the US-China trade war could certainly undercut all equity markets if it escalates further, we think both parties are incented to limit the damage to the broader economy.
Ultimately, market prices evolve as the market’s discounting of events changes. The perfection currently discounted in the United States will be hard to sustain.
Kevin Rosenbaum, Deputy Head of Cambridge Associates’ Capital Markets Research