The European economy is enjoying strong fundamentals. Growth should continue in 2018, providing support for both equity and bond markets. But given lingering political risks, potentially tighter monetary policy and elevated markets, there could be periods of distress.
By Dean Tenerelli and Mike Della Vedova
The European economy is enjoying strong fundamentals. Growth should continue in 2018, providing support for both equity and bond markets. But given lingering political risks, potentially tighter monetary policy and elevated markets, there could be periods of distress. We believe investors will need to focus on identifying strong companies in sectors that can benefit from growth and endure any potential disruption.
Despite Brexit, growing populist forces in a number of countries and the unofficial Catalan referendum, the eurozone grew at a healthy rate throughout the year, seemingly impervious to negative geopolitical events. The big question for 2018 is whether this resilience will continue. At a fundamental level, the prospects look good: Europe is at an earlier stage in the credit cycle than the US, corporate earnings are strong, and the recovery appears both broad and sustainable.
However, while political threats have abated, they haven’t gone away altogether. The Catalonia situation remains in flux, anti-establishment forces look set to perform well in the upcoming Italian election, and the Brexit drama could yet boil over. Other countries could seek to leave the EU, while populist movements could make gains in national parliaments, which could threaten EU unity.
The European Central Bank (ECB) plans to scale back its asset purchase programme in 2018, but has promised it will continue its efforts to simulate the economy for “as long as necessary”, and won’t raise rates until it has stopped purchasing assets. This suggests that loose money could remain in place for the next few years at least. But if the economy suddenly goes into overdrive, the bank could be forced to tighten more aggressively, which would put pressure on bond markets. In the US, markets expect the Federal Reserve to raise rates three times in 2018 and adopt a fairly moderate approach to shrinking its balance sheet. However, if it surprises the markets with more aggressive tightening, the European economy could suffer.
We believe European equities could continue to advance if corporations can build on their recent solid growth. We think the best opportunities in 2018 exist among high-quality, growth-generating companies that could be boosted by economic growth. The telecoms sector, for example, is undergoing a period of consolidation, with margins expanding. European banks look cheap and stand to benefit from the gradual removal of monetary stimulus by the ECB, although they could be hampered by the slow pace of interest rate rises.
A number of innovative software service companies are disrupting the industry and delivering excellent rates of compound growth. Although car makers look expensive and are facing complex regulatory challenges, we we see opportunities among equipment suppliers to the industry, especially those using innovative technologies to develop irreplaceable parts.
Defensive sectors such as consumer staples look less attractive, but have started to look cheaper recently. If they fall further, opportunities may arise among companies that offer good earnings growth, strong returns and healthy dividends.
European corporate bond markets have powered ahead in 2017, leaving them potentially vulnerable. With strained valuations, persistent political risks and central banks seeking to tighten, careful selection appears prudent. We’re focusing on individual company issuers that have the potential to improve regardless of wider market conditions. This strategy may lead to underperformance during market rallies, but we see this as a more effective way to navigate monetary tightening and potential volatility.
Selected high-yield and investment grade issuers in media, cable, telecommunications and packaging companies all appear attractive on several measures. Some investment grade financial issuers also appear set to carry their strength into 2018.
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