24 Jan 2020

In our last Review we highlighted that the recovery over the summer in Eurozone money supply should lead to an improved reading in European purchasing manager data. As we noted in the introductory paragraphs, Europe has seen much of its disappointment in growth concentrated in Germany and Italy.

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An analysis of the components of economic activity indicates that much of this shortfall can be laid at the door of manufacturing and thereby international demand via exports.  In particular the automotive sector of European manufacturing has had a torrid time.  Eurozone domestic demand rose by 2.3% over the year ending in September, well ahead of GDP, which was depressed by very weak trade activity levels.  Such anaemic rates, plus the prospect in the late summer that the trade friction would intensify, persuaded the European Central Bank (ECB) to cut interest rates again and restart its asset purchase programme.
That marked the final action of the outgoing ECB President Mario Draghi before handing over the reins to Christine Lagarde.  As is becoming well understood, she is not a fan of even looser monetary policy, but is increasing the pressure on politicians across the Eurozone to implement a more supportive fiscal approach, in a magnified version of Mr Draghi’s valedictory message on leaving office. The last few months featured a material bounce in the ZEW Economic Sentiment Indicator for Germany, which in the summer had plumbed depths last seen in 2009, staging a recovery from -44 to +11, the most positive reading since the spring of 2018.
Eurozone Governments can spend more in the future

Money supply indicates PMI should bounce in the next few months

Source: Citi Research Nov 2019

The chart illustrates how much austerity has been brought to bear in Europe since the financial crisis, with the combined Budget Deficit now only about one-tenth of the level reached a decade ago.  The scale of this deficit at 0.8% of GDP compares with 2% in the UK, 5% in the US and 4% in Japan; the principal reason for this anomaly is of course Germany, which is still running (and advocating) a surplus of more than 1%.  This gives Germany ample room to become more stimulatory, a thought reinforced by its very low debt levels (only 60% of GDP compared with more than 85% across the Eurozone as a whole).
Historically Germany had a high reliance on nuclear energy, which contributed almost a quarter of electricity production but, following the Fukushima disaster in Japan, many of the German plants were closed and now only seven of the original 17 remain operational.
How Germany responds to this opportunity is however less clear.  One option, which would allow them to loosen the purse strings but adhere to their policy framework of rules known as black zero and the debt brake, is provided by the movement towards greener energy production.  Historically Germany had a high reliance on nuclear energy, which contributed almost a quarter of electricity production but, following the Fukushima disaster in Japan, many of the German plants were closed and now only seven of the original 17 remain operational.  However the closure of that nuclear capacity has made the country more dependent on coal and lignite as a source of electricity generation (28% at the last count), until such time as more capacity in renewable form through wind and solar is fully developed.  A temporary package of fixed capital investments, by measures designed to accelerate the number of renewable energy projects, would endorse Germany’s green credentials as well as boosting the economy in the near term and is eminently justifiable.
If economic activity in Europe has proved a disappointment, compared with hopes at the start of 2019, then conversely corporate profit expectations for the same year have been surprisingly resilient.  Projections have been revised down but relatively modestly and are still for faster growth than is expected from Wall Street.  Moreover expectations for the growth rate in 2020 are intact, compared with a downward revision of about 7% for global profits generally. 
During the final quarter of 2019, the total return from European equities lagged that from Wall Street in local currency but, when calculated for a sterling investor, were almost the same.  The lower rating for European equity markets, a P/E of less than 15X, together with an appealing dividend of more than 3.5%, one of the highest in the developed world at a time when investors are hungry for income, should leave shares well placed to profit from any increased confidence about global economic growth.  

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