Europe’s Main Event: Economics vs. Politics

European equities have been in the tank for years, as the region has struggled with lackluster growth since the 2007-2008 financial crisis. But just as it appears that European stocks may be poised to benefit from higher global economic growth levels and an uptick in earnings, potential fallout from national elections—both in the region and from abroad—may impact their progress. Here, Philippe Brugere-Trelat, executive vice president and portfolio manager, Franklin Mutual Series, discusses the competing forces at work in likely determining how the European economy and its equities fare this year.

After a tumultuous 2016, European equities may be in for a relatively smoother ride in 2017. Economically speaking, the outlook for Europe is improving, in my view, and the most recent data shows economic confidence is at its highest level since 2011.1

As 2017 unfolds, I believe European equities may benefit from two factors. First, the recent acceleration in global economic growth will likely increase demand for Europe’s exports. Exports comprise about 27% of the eurozone’s gross domestic product,2 and that percentage is even higher for Germany.

The second factor, which is likely a consequence of the first, is the inflection point we have seen in European corporate earnings. Corporate profits in Europe have risen since their trough in July 2016, and for the first time in several years, on a year-on-year basis, earnings growth has risen above zero. European earnings had languished for years because, by and large, European companies have been price-takers (companies that have little influence on the prices they charge) rather than price-setters, and were hampered by concerns about deflation and anemic economic growth in the region. With the pick-up in global economic growth, we are even seeing some signs of inflation, which should have a positive impact on pricing and, by extension, on European companies’ margins.

Political Uncertainties

Although the economic picture appears brighter, the political outlook has become cloudier. First, there’s the fallout from the United Kingdom’s vote in June 2016 to leave the European Union (EU). Since the vote took place, the United Kingdom has been in a kind of suspended animation, and very little has happened, although behind-the-scenes positioning has taken place between the United Kingdom and the EU regarding how to pursue future negotiations.

Even if the plans to implement “Brexit” start in March, as indicated by UK Prime Minister Theresa May, the process will likely be long and drawn out, which in and of itself generates uncertainty. The negotiations could become acrimonious, which may put the United Kingdom in a difficult situation. I believe the economic impact of a “hard Brexit” (where the United Kingdom gives up full access to the single market and the customs union with the EU), would be much harsher on the UK economy than on the EU’s, but it would not inspire confidence in the rest of Europe.

Second, it’s possible that national elections occurring this year may propel populist, anti-EU parties to power. I believe the prospect for that in France is limited, and even less so in Germany, but I would not say it does not exist.

On the other hand, a populist party may gain traction in the next Netherlands elections, although I doubt that it would get enough votes to form a majority government by itself. In Italy, we still do not know whether there will be an election this year, because the main objective of the current temporary government is to reform the electoral law so that the populist Five Star party cannot benefit from the law’s current form.