European tensions: The market reaction

David Joy, Chief Market Strategist, Ameriprise Financial

August 2018

Key Points

  • The European Union is facing a series of economic and political challenges
  • Recent trade disputes only add to a long list of issues
  • Investors may consider a “wait-and-see” approach to European stocks

These have been challenging times for the European Union (EU), both economically and politically. Recent events, including the planned exit of Great Britain from the European Union and the growing political strength of populist and nationalist candidates, have raised both short- and long-term questions about the future of this organization of diverse nations.

The 28-member European Union represents the world’s second largest economic entity, accounting for 22% of global Gross Domestic Product (GDP). This number trails only the U.S., which accounts for 24% of global GDP. 1

In 2017, European countries experienced a period of economic growth. Last year’s economic output in the EU grew by 2.4% to a total of nearly $18 trillion based on the current exchange rate. 2 By comparison, U.S. GDP grew by 2.2% to $19.5 trillion in 2017.3 EU companies represent approximately 20% of the market cap of the FTSE All-World index. 4

European economic growth tapers off

After experiencing robust growth in 2017, European economic growth has slowed this year, and it is not clear whether this slowdown is temporary or something more persistent. After posting five straight quarterly growth rates of 0.7%, the EU’s pace in this year’s first quarter fell to 0.4%.5

Surveys of investor confidence in the EU and expected economic growth have fallen sharply due to rising trade friction. 

Trade continues to be important to the EU economy. According to the 2015-2016 factbook from the Organization for Economic Cooperation and Development (OECD), exports totaled 44% of its GDP and imports totaled 41%. The U.S. is the EU’s largest trading partner, consuming 20% of its exports.

The ripple effect of the EU’s political issues

Fast approaching on the political calendar is March 29, 2019, the effective date of “Brexit,” when the United Kingdom (UK) officially leaves the EU. The UK’s exit from the EU may have a significant impact on the region’s broader economy. Although its 2017 economic growth of 1.8% lagged behind the overall EU, the UK economy accounts for 15% of total EU GDP. 6 It is the second largest economy behind only Germany.

While nine months may seem like sufficient time to formalize the details of the future relationship between Britain and the EU, the clock is ticking. Many issues remain unresolved – even within the British government itself – regarding trade and customs, the border between Northern Ireland and the Irish Republic, and the ability of EU citizens to travel to Britain for work.    

The political uncertainty in Europe extends to Italy as well, where the new government is attempting to reconcile its campaign promises to ramp up fiscal spending with the realities of the budgetary discipline required of EU members. Italy is also confronted with slow economic growth and high debt levels. Its fiscal intentions could clash with the EU when the government submits its 2019 budget in early October, and markets are nervous. Although currently below their highest levels, the country’s bond yields remain elevated from when the new government was formed in May.

In Germany, the economic stalwart of the EU, Chancellor Angela Merkel’s coalition government is experiencing infighting over immigration policy. The DAX stock index (a benchmark index of German stock market performance) fell 4.7% in the first half of 2018, and business sentiment in that country has declined. 7

Central banks playing a role

Monetary policy is also slowly evolving toward normalization. The European Central Bank (ECB) recently announced that its quantitative easing bond buying program, which began in 2015 to boost economic growth, will start to be phased out at year-end.

Typically when central banks keep interest rates flat or lower, the purpose is to help spur economic growth. In an effort to keep economic growth from stalling, the ECB also promised to keep interest rates unchanged for roughly the next twelve months.

Stock markets reflect concern

This has been a year of lackluster performance for Europe’s stock indices. One broad measure of EU equity performance is the Europe Stoxx 600 index, which has struggled this year. The broad index fell 2.4% in the first half of 2018, while the more narrowly-defined Eurozone specific Stoxx 50 index has declined by 3.1%.6

European stocks are currently priced at a discount compared to U.S. investments.

With a price-to-earnings (P/E) ratio of 14.5 times earnings8 based upon expected 2018 results, European stock prices are relatively low. This compares to a current P/E ratio of 17 times earnings for U.S. stocks.8 The cheaper valuation for European stocks reflects, in part, lower expectations for corporate profit growth in Europe in the coming months.

A cautious outlook for European stocks

The Ameriprise Global Asset Allocation Committee has reduced its exposure to European equities as the EU sorts through its challenges. Improving economic growth after the early year slowdown would certainly support the investment case for Europe, and there was some evidence of this at the end of the second quarter. Forecasts for full-year economic growth in Europe have generally held steady at more than 2%.9 Nevertheless, with forecasts of faster growth in both economic activity and corporate earnings in the U.S., the immediate outlook for domestic stocks looks relatively more attractive.

To determine the best investment approach for your portfolio, be sure to consult with your financial advisor to review how the current environment applies to your circumstances.

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