Europe: another crisis in 2017?

While US stocks have soared to new peaks this year, the picture across the Atlantic has been less inspiring. The pan-European Euro Stoxx 600 index hasn’t hit a record in almost two years, and is marginally down on its 1 January 2016 level. But in the last few weeks the macroeconomic backdrop has improved. The eurozone could well grow faster than the annualised pace of 1.4% it reached in the third quarter, says Digby Larner in Barron’s.

Eurozone heavyweight Germany in particular “appears to have found a higher gear”, says Richard Barley in The Wall Street Journal. The Ifo business confidence survey has risen to a three-year high. Even better, a component of the survey tracking businesses’ expectations for the future looks buoyant, and this indicator has always been closely linked to business investment. “Investment has been one of the key weaknesses in European growth,” says Barley.

The eurozone relies far more on exports than other major economic regions, so if Trump’s stimulus does kick in, raising activity in the US-led global economy, the earnings of Europe’s listed multinationals should get a boost. Ever since the global financial crisis, banking on a lasting European earnings recovery has been like waiting for Godot. Profit growth has been dampened by the long recession, high labour costs and unusually slow global growth.   

All of which sounds bullish for European equities, if it weren’t for the tendency of the bloc’s chronic crisis to flare up and negate incipient economic upswings. While Europe’s ability to muddle through and apply short-term fixes to its flawed currency should never be underestimated, it faces a daunting series of potential flashpoints next year.

The main one is the French presidential election. The nationalist and anti-EU candidate Marine Le Pen is not expected to win, but then neither were Trump and Vote Leave. She intends to call a referendum on France’s EU membership – 54% of voters have a negative view of the organisation – which would surely crumble if a founding member left.

The same would apply to the single currency if Italy quits. Given the huge loss of competitiveness Italy has endured owing to its euro membership, its departure is surely “not a matter of if but when”, as Roger Bootle of Capital Economics says in The Daily Telegraph. Italy is muddling on for now, but the German national elections next autumn may harden northern attitudes towards bailing out the south and poison intra-European relations further.

That would be especially inconvenient for Greece, where talks between Athens and its creditors have broken down over the latest review of Greece’s 2015 bailout. There may now be an early election, another potential thorn in the eurozone’s side. The new year may see a sadly familiar scenario in Europe: political turmoil negating reasonable economic fundamentals.

The worst is over for sterling

Big movements are rare in the forex market, which makes sterling’s plunge after the Brexit vote all the more striking. It is now down by around 16% against the dollar since the referendum, having been around a fifth cheaper in mid-October. It has recently clawed back ground against the euro too, hitting a three-month high.

Sterling was always vulnerable to a downward adjustment thanks to our towering current-account deficit. The downgrade should help close our shortfall with the rest of the world, while there are several short-term reasons to assume that the slide is largely over; indeed, a near-term bounce looks likely.

The focus has shifted to selling the euro thanks to Trump’s election and renewed political risk in the eurozone. What’s more, as Morgan Stanley notes, sterling has a “hard Brexit” priced in. As talk of a transitional deal or a fudge has spread, investors have become less concerned that we may simply crash out of the single market. Meanwhile, the economic data “are holding up well”. Morgan Stanley reckons the euro will fall to 77p, from 84 today, by the end of next year.

Merryn

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