Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.
No, we don’t think so. While euro area economic activity has weakened meaningfully, with real GDP growth falling to its lowest annual pace (1.1%) since 2013 in third quarter, strong equity returns aren’t dependent on robust economic growth. Ultimately, we continue to like the bloc as part of a risk-controlled overweight to global ex US equities funded from US equities.
To be sure, economic weaknesses are not limited to the euro area. They are visible globally and linked to the protracted nature of US-China trade tensions. What’s striking is just how much tariffs between these two economic giants have risen —US importers now face average tariffs of 21% on goods from China (a 17.9 percentage point [ppt] increase from January 2018), while US exporters face average Chinese tariffs of 21.1% (a 13.1 ppt increase from January 2018), according to the Peterson Institute of International Economics. These protectionist policies and the resulting uncertainty they fostered have slowed the pace of global manufacturing, trade, and investment.
But the slowdown in euro area activity has been more pronounced than in many other developed countries. To a large extent, this reflects the bloc’s high dependency on global trade. At the end of 2018, euro area exports accounted for just less than 20% of the bloc’s output, higher than the same measure for the United Kingdom (16%), Japan (15%), and the United States (8%). In Germany, where exports represent nearly 40% of GDP and the large auto industry is struggling to adjust to new emissions standards, the downturn has been acute. Overall, German manufacturing contracted by 4.9% in the year ending in second quarter, raising the specter of a possible technical recession ahead of the mid-November third-quarter GDP release.
Two other policy quagmires weigh on euro area sentiment. The first is Brexit. With a three-month flexible extension added to the 31 October Brexit deadline and Prime Minister Boris Johnson’s conservatives leading in early opinion polls ahead of the 12 December election, prospects of an orderly Brexit have seemingly improved relative to a few months ago. But nothing is assured, considering the former Prime Minister Theresa May’s poor result following her initially confident decision to call an election. And even an orderly Brexit will result in higher trade barriers. The second policy quagmire relates to the European Central Bank. Incoming president Christine Lagarde has the uneasy task of stewarding the bank just as it pushes its deposit rate further into negative territory, restarts its asset purchases program, and struggles to boost euro area inflation.
Still, euro area pessimism may have reached a cyclical peak. While economic surprises have been sharply negative, recent readings have been less negative, according to a Citigroup index. Similarly, while the economic mood remains poor across the euro area, it recently rebounded from a roughly eight-year low, according to a monthly survey of financial market participants conducted by ZEW. Also, US-China trade tensions may have peaked, with President Trump backing off a planned escalation in tariffs and announcing a “Phase One” truce last month. While President Trump could again embrace tactics of brinksmanship in his China trade negotiations, it is possible he may be less willing to potentially jeopardize the US economy as Congress’s impeachment inquiry gains momentum and the 2020 presidential election nears.
In any case, our preference for euro area equities is rooted in valuations, not whatever the next tweet brings. While US corporate fundamentals are strong, euro area equities and their global ex US counterparts are historically cheap. In fact, the relative multiple of our composite normalized price–earnings metric has only been lower in 1% of historical observations going back to 1995. Such low relative valuations have been reached after an 11-year period of underperformance, the longest and greatest magnitude of underperformance on record, according to MSCI indexes. Given the extreme divergence in equity valuations and the cyclical nature of return patterns, a risk-controlled overweight to euro area equities and their Global ex US peers funded from US equities remains prudent, despite current economic headwinds.
Kevin Rosenbaum, Deputy Head of Cambridge Associates’ Capital Markets Research