Market analysis: EU badly in need of structural reforms

The Brexit vote was a wake-up call for European leaders, suggesting there is something profoundly dysfunctional in the union’s set-up that needs to be fixed.

The European Central Bank in Frankfurt, Germany. Its quantitative easing programme appears to be reaching its limit. Boris Roessler / AFP

In its current form, the European Union is like a bicycle: it needs to keep moving forward or it will fall over. The EU has faced many challenges over the past 60 years, but 2017 may bring the greatest yet as political uncertainty runs high ahead of crucial elections across the region.

The global recession in the late 2000s and Europe’s subsequent sovereign debt crisis slowed the EU’s progress considerably. Although the European Central Bank’s quantitative easing (QE) programme supported the region’s financial system, rising social tension and Euroscepticism now pose some threat to the union.

The Brexit vote was a wake-up call for European leaders, suggesting that there is something profoundly dysfunctional in the union’s set-up that needs to be fixed. As the ECB’s QE programme appears to be reaching its limit, structural reforms are becoming increasingly important. While this year’s elections are a risk, they also present an opportunity for Europe’s leaders.

Looking past the politics, the outlook is brighter from a fundamental perspective. Economic activity in Europe is improving. Leading indicators such as the purchasing manager indexes (PMI) have rebounded strongly and suggest GDP could grow at its fastest pace in five years. Meanwhile, the Euro Area Economic Sentiment Indicator is back to its pre-crisis level and consumer confidence remains resilient.

Along with this pickup in economic activity, corporate earnings across the region have recently inflected. As we come to the end of fourth quarter 2016 reporting season in Europe, consensus profit expectations have moved up, bucking a five-year trend, with double-digit growth anticipated for the year ahead.

After years of sub-trend growth, European earnings are still about 20 per cent below their peak, while US companies are reporting record profits. This presents a significant opportunity.

The disparities between countries create additional investment opportunities.

Germany in particular is a beneficiary of global growth and reflation, given its high weighting towards cyclical companies that do well when economic indicators are in expansionary territory. German domestic activity is also healthy with expanding credit growth, house prices and consumption indicators. Meanwhile, valuation remains unassuming with the German Stock Index (DAX) trading at historically low price-earnings multiples when compared with other markets.

Concerns that the European bicycle seems to be wobbling leave investor sentiment negatively tilted towards the entire region.

Many investors are underweight, or even avoid it altogether. The improvement in outlook could reverse this bias, for in a world where equity valuations have expanded, Europe stands out as a value market that also offers an attractive dividend yield. Underappreciating Europe’s potential for recovery could be a costly mistake. Indeed, the region represents about 20 per cent of the world’s GDP and a similar proportion of global equity markets so avoiding it can have a significant impact on portfolio performance.

Could 2017 be the “make or break” year for Europe? A number of political flashpoints threaten the region’s stability. Yet the EU project was built on the aftermath of crisis and has proven its ability to endure challenging times.

If the EU holds together following the elections in the Netherlands, France and Germany, investors are likely to be encouraged. With more, less or just a different type of integration, the region remains home to some of the world’s strongest companies and a great environment for stock pickers.

Julien Lafargue and Grace Peters are equities strategists for Eur­ope, Middle East and Africa at JP Morgan Private Bank

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