By Don Smith, Chief Investment Officer at Brown Shipley
The skies over the Eurozone brightened significantly in 2017 as the single currency area moved into the position of vanguard of global economic growth.
This improvement is certainly timely, as the continent faces a host of looming political challenges in the coming months. However, the strength of economic recovery across the region mitigated many of the risks that investors have become accustomed to in relation to euro assets.
Through much of the past year, activity data has consistently surprised to the upside – not just in the core economies but in the periphery as well. Importantly, the Eurozone unemployment rate has been on an unrelenting downward trajectory since mid-2013. In addition, the region’s economy grew by 2.5% in 2017 – the strongest growth since the 3% rate seen in 2007.
An upwards growth trend
Today, indicators firmly support a continuation of this upwards trend. Investor, consumer and business confidence has surged. Companies are generating high levels of free cash flow, and the outlook for fixed investment spending is positive.
Surveys point to a sharp increase in planned corporate investment spending in 2018, particularly in Germany and France – with the latter partly related to the reform policies of the Macron government.
The role of corporate investment as a swing factor in the Eurozone growth dynamic means that a resurgence here typically carries a much broader positive message about the outlook for GDP across the region. Investment spending raises productivity and wages, and can prolong the business cycle upswing.
It is also important to keep in mind the contribution that the strength of the global economy is making to Eurozone growth, including directly through export demand. The Eurozone’s high exposure to such demand means that the ongoing buoyancy of the global economy should continue to lend support.
Risks to Eurozone expansion
However, despite all of these positive factors, there remain clear risks to sustained Eurozone expansion. In addition to Britain’s impending exit from the EU and uncertainty over Germany’s coalition government threatening the stability of the Eurozone’s largest economy – the outcome of the upcoming Italian general elections in May could prove crucial.
Despite being the third-largest country in the Eurozone, Italian GDP per capita is barely higher than when the euro was created some 18 years ago – and was left behind in the wake of the global financial crisis, stalling at a time when other major Eurozone countries regained ground.
Today, however, the Italian economy has joined the rest of the Eurozone as it enjoys a broad economic upswing with markets appearing far less concerned about risk in relation to the election.
While many of Italy’s economic troubles lie in its banking sector, there are signs of a turning point being reached.
Actions in support of its banking sector picked up in 2017: recapitalisations have increased, the stock of non-performing loans has fallen and failing banks are being shut down. This process still has some way to go, but it should reinforce upward momentum in the economy.
Additional friction in the Eurozone will be generated by the ongoing process of reform. The election of President Macron in France, in particular, has highlighted increased support for reform across the Eurozone and this has already begun to manifest itself in revisions to the French labour market law.
Moreover, despite representing a clear and present danger to the Eurozone economy, Brexit also seems to be helping to reduce risk by acting as a catalyst for closer political integration between other EU members. These countries are pulling together in common cause to protect the Union from the economic and political challenge that Brexit represents.
Robust investor outlook
Doubtless, 2018 will be a challenging but important year for the Eurozone.
Despite the clear risks ahead, government deficits have been contained across the Eurozone, debt as a percentage of GDP has been falling and the economy boasts a current account surplus.
These factors should help reinforce investment confidence against the internal political storms that are part and parcel of the process of unifying countries in a continent as old and culturally diverse as Europe.
As the ongoing process of reform gains traction – in France, Italy and elsewhere – and as the economy continues to strengthen, stability should return to the region and, with it, investor trust.
About Don Smith
Don became CIO at Brown Shipley in 2016, having joined the business as Deputy CIO in 2015. Don joined Brown Shipley from iCap where he held the role of Chief Economist. Prior to Don’s 14 years at iCap, he was a Senior Economist at HSBC and a founder member of the team at Roger Bootle’s Capital Economics unit.