Summary

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  • The recent acceleration of Eurozone economic activity has gone largely unacknowledged by global investors. This Macro Insight aims to understand the reasons behind the pickup, assess its sustainability and outline the investment implications for Eurozone assets
  • As measured by our ‘Nowcast’ model of real-time economic performance, stronger Eurozone activity since October 2016 (to levels last seen in 2011) predominantly reflects an uptick in sentiment indicators, particularly the manufacturing PMI
  • This comes at a time when the Eurozone labour market continues to tighten, supporting consumption, whilst a weaker trade-weighted euro (versus 2014 levels) and a recovery in regional fixed investment has boosted the manufacturing sector. Improving credit conditions and, importantly, an easing of fiscal austerity by many Eurozone governments have also been supporting factors
  • We expect a number of drivers to maintain positive growth momentum. Crucially, the labour market has further room to tighten, and we anticipate monetary policy to remain accommodative for a while longer
  • In this positive and sustainable growth environment, a relatively high Eurozone implied equity risk premium supports our overweight view on the region’s equities
  • Meanwhile, for Eurozone government bonds, the recent selloff has improved prospective returns. However, we think they still look low relative to competing asset classes. Amid rising headline inflation and expectations of the ECB further tapering its bond purchase programme, we remain underweight in this asset class
  • Similarly, prospective returns on European corporate bonds look unappealing on a relative basis, and are also vulnerable to ECB tapering. We retain our neutral positioning, with a preference for US credits

The Eurozone economy remains a key positive growth story

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The Eurozone economy has seen an acceleration of activity since October 2016, a remarkable sign of resilience in the face of the “uncertainty shock” of the UK’s Brexit vote. Our Nowcast model (which estimates real-time economic performance) is now tracking growth in Eurozone underlying activity at just above 3 per cent month-on-month (mom) annualised – levels last seen in 2011, just before the Eurozone debt crisis was at its zenith (Figure 1).

Figure 1: Eurozone growth in underlying activity from our Nowcast model

Eurozone growth in underlying activity from our Nowcast model

Source: HSBC GAM Global Investment Strategy, as of February 2017

Following a period of above-potential growth that began in mid-2014, this acceleration has gone largely unacknowledged by investors. This Macro Insight aims to understand the drivers of this positive growth story, question its sustainability and discuss the investment implications for Eurozone assets more generally.

What is behind this pickup in activity?

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Our Nowcast model tracks a host of economic indicators to determine underlying activity. In the case of the Eurozone, the recent pickup predominantly reflects an improvement in sentiment indicators. This has occurred across all major Eurozone economies and encompasses both the industrial and services sectors.

In particular, the manufacturing PMI has seen a marked gain, with the January headline figure reaching close to a six-year high. Meanwhile, the services reading jumped higher in November, and although it has more recently stabilised, the 3-month moving average is near a 1-year high. Elsewhere, upbeat confidence in the region is reflected in the January reading of the European Commission Economic Sentiment Indicator ticking up to its highest level since March 2011.

The improvement in the services sector is unsurprising given the backdrop of a gradually tightening labour market. The Eurozone has added around 400,000 new jobs per quarter since the beginning of 2014, with the unemployment rate dipping to a lower than expected 9.6 per cent in December 2016. This additional consumer spending power is reflected in annual retail sales growth trending comfortably above 2 per cent year-on-year (yoy) over the past year, a feat last achieved before the financial crisis in 2007.

According to Markit, the recent improvement in the manufacturing PMI has been supported by “the depreciation of the euro playing a key role in helping drive new sales in export markets”[1]. A robust recovery in Eurozone fixed investment is also supporting industrial activity. German factory orders of capital goods coming from the Eurozone (ex. Germany) – a reliable early indicator of investment demand in the region – surged to 16.1 per cent yoy in December on a 3-month moving average basis.

Not only does this reflect an erosion of spare capacity in the region since the financial crisis, but also improving credit conditions and, importantly, an easing of fiscal austerity by many Eurozone governments. Hard industrial output data is starting to reflect the upbeat PMI numbers, with November’s unexpectedly large 1.5 per cent mom increase in industrial production pushing annual growth to its highest level since January 2015 on a 3-month moving average basis.



[1] Markit January final PMI Press Release (625KB, PDF)

How sustainable is Eurozone growth momentum?

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A number of factors suggest this positive Eurozone growth story can be maintained. Crucially, growth is being driven by a slow reduction in spare capacity, most readily visible in the gradual but steady decline in the unemployment rate, translating into stronger private consumption. Amid a backdrop of subdued core inflationary pressures, ultra-low rates are likely to persist for a while longer, not only supporting consumer borrowing costs but also serving to keep debt servicing costs to a minimum.

Meanwhile, although rising headline inflation (mainly on the back of commodity-price base effects) may eat into real disposable income, and thus household spending, the acceleration in prices is expected to be extremely gradual. In its latest set of staff forecasts, the ECB expects headline CPI inflation at just 1.3 per cent in 2017.

Perhaps more significantly, the income-eroding effects of inflation should be offset by further gains in employment, boosting total income earned. In some economies – notably Germany – labour shortages should also place upward pressure on wage growth, already running at 3.5 per cent yoy (against a historical post-reunification average of 2.5 per cent).

Resilient business confidence and accelerating credit growth to non-financial corporations (Figure 2) suggest that the uptrend in investment could continue. Financial conditions should remain loose amid ECB policy support (e.g. TLTROs[2]) and a recovery in banking sector health (although pockets of weakness remain, most notably in Italy). Higher investment also increases the productive capacity of the economy, supporting longer-term growth prospects.

Figure 2: The recovery in Eurozone investment is set to continue amid supportive factors

The recovery in Eurozone investment is set to continue amid supportive factors

Source: ECB, Bloomberg, as of February 2017

Stronger growth outside of the Eurozone, particularly in the Eurozone’s largest export destination – the United States – could also boost the region’s manufacturing sector. However, we recognise that weak global trade growth and “reverse globalisation” risks are potential headwinds in this respect. A “soft-Trump” scenario, whereby the US President pushes ahead with fiscal stimulus and other growth-enhancing domestic policy initiatives, whilst limiting the use of trade-protection measures would be the optimal outcome.

Finally, domestic political risks remain a key risk to the outlook, and may have recently weighed on investor risk appetite towards the region. In particular, this year’s general elections in the Netherlands, France, Germany and possibly Italy pose potential threats to the stability of the European project. For now, however, barring a major shock – such as a Le Pen victory in France – there is little reason to suggest an imminent threat to EU stability. We also remain encouraged by the post-Brexit vote resilience in confidence, both in continental Europe and the UK.



[2] Targeted longer-term refinancing operations (TLTROs) are Eurosystem operations that provide financing at attractive conditions to banks for periods of up to four years in order to stimulate bank lending to the real economy.

Investment Implications

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In our view, Eurozone equity valuations remain attractive – with an implied risk premia around 5 per cent versus US Treasuries in some markets (such as Germany). Amid a backdrop of highly accommodative ECB policy support, we think there are strong arguments that positive macro momentum can be sustained. Crucially, this should continue to support the region’s earnings prospects. This backs up our overweight view on the region’s equities, which we prefer to the US, where the margin-of-safety versus bonds is thinner.

For the region’s government bonds, the recent selloff (on the back of rising inflation expectations and spill-over effects from the Trump “reflation trade”) has improved prospective returns. Importantly, however, they still look low relative to competing asset classes. Furthermore, robust Eurozone growth and rising headline inflation is a bond-unfriendly environment. We also expect a crucial pillar of support – the ECB’s Asset Purchase Programme (APP) – to be tapered further at the end of the year. Overall, therefore, we anticipate Eurozone government bond yields to climb higher still, and therefore retain our underweight position in this asset class.

Similarly, although European corporate bonds benefit from a relatively earlier stage in the credit cycle versus the US, we think prospective returns look unappealing on a relative basis. European corporate bonds also remain vulnerable to a tapering of the ECB’s Corporate Sector Purchase Programme (CSPP), a sub-component of the wider EUR60bn a month APP. We remain neutral for the time being, with a preference for US credits.

Finally, at current euro/US dollar levels, prospective returns point to appreciation, although this is not enough to offset the expected negative interest-rate differential versus the US dollar (the “cost of carry”). In our view, this justifies holding euro-denominated assets on a hedged basis from the perspective of a US dollar investor.

Disclaimer

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