Posted on 26 June 2015
"“Europe without Greece is like a party without Drugs” (Cacao Rocks)."
Yet another Greek denouement
Risks certainly remain with regards to the Greek situation – the two sides have not yet found agreement and the looming rolled IMF payment and an increasingly precarious domestic Greek banking sector suggest that this is no time for complacency. Nonetheless, a deal feels a little more likely as we look forward to this weekend’s set of crisis meetings than it did at the beginning of the week. Before too long we still suspect that investors may be able to shelve the ongoing Greek crisis for a little while. Negotiations with regards to the third bail out, if the two sides make it that far, may not be any less fraught or dysfunctional than the recent talks and strops, but markets with their customary ADHD are perfectly capable of moving on.
Certainly the behaviour of equity markets in Europe this week suggests as much, with the Euro STOXX 50 rising over 4% on Monday. With continental European equities having already returned 15% in local currency terms this year – Is it too late for investors to enter the fray?
The European economic backdrop outside of Greece has been on an improving trajectory since the end of last year. This week we had further evidence that a durable recovery is taking hold. Business confidence in both the manufacturing and services sectors continues to pick up across the region, even in the face of Greek concerns, as evidenced by preliminary data for June. This increasing corporate sprightliness has its origins in both the domestic and international backdrop.
From the International perspective, the US economy continues to look little different from its pre crisis incarnation in all but monetary policy, with the same broadly true of the UK. Labour markets are moving in the right direction across the developed world and this should result in decent demand for Europe’s wares.Those that pinned their hopes for Europe on a devaluation of the Euro and the beneficial effect of oil prices may be starting to waiver a little. However, we are sceptical of the importance of currency in the context of international demand as we’ve noted before. The relationship between currency moves and output growth look thin to nonexistent on the available data, much as they do for other developed economies. This makes sense – for an economy selling little other than base commodities for example, currency would surely be an important determinant of external demand. However, in Europe and in much of the rest of the developed world, base commodities are a very small part of an export base which is far less vulnerable to capricious swings in currencies. More practically, any readers working in businesses reliant on global supply chains will recognise that they are often significantly less flexible than regularly implied by the commentariat.
This does not mean that currencies don’t show up in corporate results, they do. However, the effect is, more often than not, translational (and therefore temporary) rather than transactional and more durable.
As a net importer, falling oil prices have no doubt been helpful to the European economy. However, in Euro terms, the fall in oil price was less than that experienced in dollars in any case and there tends to be more institutional interference in the price that consumers and businesses eventually receive in Europe vs. the US.
With the domestic and international demand backdrop looking increasingly healthy, we should start to see the yawning gap that has opened up between European and US corporate earnings over the last few years start to narrow. We are already seeing earnings estimates for the region’s corporate sector start to pick up more meaningfully, which should bode well for equity investors in the region. There obviously remains much for investors to keep an eye on – the political backdrop will remain messy for a while yet and it’s hard to see a durable solution to the crisis in the Eastern Ukraine on the horizon. Nonetheless, continuing corporate earnings growth and a still attractive dividend yield continue to make European equities a risk worth taking in the context of a balanced portfolio diversified across the asset classes and geographies.
William Hobbs, Head of Equity Strategy, Europe