Eurozone Outlook: Amid Growth Potential, Political Risks Linger
Evidence points to modest growth in Europe in the year ahead – but investors should be mindful of geopolitical risks.
Indeed, President Trump’s re-election campaign is coming into full swing, and he needs to ensure that the US economy holds up throughout next year. Sitting presidents usually win re-election in an expanding economic scenario, and while there is no guarantee, his chances will be greatly helped by a solid economic backdrop. In addition, the trade dispute has hurt some of the president’s base sectors – farmers and manufacturing. It is therefore no surprise that a sharp rise in agricultural purchases from China is part of the initial trade agreement. Nonetheless, Trump cannot be seen as “soft on China,” or he risks getting attacked from hard line Republicans and Democrats alike. As such, he needs to navigate carefully, suspending upcoming tariff increases and even possibly finding a way to roll some back, while maintaining pressure on intellectual property and technology. We do not expect a return to pre-2018 tariff levels, but we hope for some tariffs to be removed over time.
For China’s President Xi Jinping, the will to remove these hurdles from his economy is strong, as China has suffered from the trade dispute, even if targeted stimulus measures have helped limit the damage. Maintaining a decent level of growth is a key to avoiding social unrest and dissidence in China, and we expect Xi to be keen to capitalize on the recent softening of Trump’s stance.
Another geopolitical improvement is expected in the form of a Brexit resolution. While the impact on global growth would be much less than that of an easing in trade tensions, the end of uncertainty would certainly help European growth. Even if Prime Minister Johnson’s deal is not as “soft” as former Prime Minister May’s, we believe that the odds of a Brexit deal being reached are now better than the possibility of a No Deal Brexit next year. The transition period can then begin – and be extended – and businesses would have clarity.
Our 2020 economic scenario is initially based on the ongoing improvement in US-China trade relations, as explained above. In such a context, we believe that growth can recover in 2020, postponing the risks of recession. Indeed, it appears that we are already seeing an upswing in data across many major regions, implying we may have seen the bottom in most regions, though admittedly data has remained somewhat mixed.
We believe that sentiment is likely to be a key driver for a moderate rebound in activity into and in 2020, as “soft data” such as the PMI surveys show a recovery thanks to improvements in trade. Hard data such as industrial production or retail sales would also benefit from increased global demand, boosting growth.
Conversely, we believe that a re-escalation in the trade war between the US and China, or even worse with further fronts including Europe, would bring forward the risk of recession and increase the probability of a significant downturn next year.
We believe that the global economy can only withstand so much in terms of tariffs and uncertainty. Consumption has been resilient, but that is in part because businesses have squeezed their margins and borne the brunt of the higher tariff costs. However, the longer the situation lasts, the more painful for businesses, and the more likely they are to decide to pass on costs to consumers. In addition, CEOs are less likely to expand, hire and invest with ongoing uncertainty, and could start to cut costs by reducing employees.
Our base case does not assume strong fiscal expansion anywhere, so an upside to our growth scenario would come from any meaningful spending by governments, from Germany to Japan. At the same time, worries about a Warren candidacy or presidency could impact sentiment further, and if trade is not resolved by then, could lead to a quicker negative growth scenario. Further uncertainty surrounding Brexit would weigh further on Europe.
In a context of mild global improvement, we expect major central banks to remain on hold throughout 2020. The Federal Reserve has indicated that it is happy to remain on hold, barring a significant deterioration in trade or economic data releases. Indeed, it has raised the bar for a further rate cut, judging this year’s three-cut mid-cycle adjustment as sufficient for current US economic conditions. It has also raised the bar even higher for a rate hike – implying that even if growth rebounds and inflation ticks up, it will look through it before feeling the need to act. As such, we expect the Fed to remain on hold.
One of Mario Draghi’s last acts as European Central Bank (ECB) chief was to deploy a new round of stimulus – including new asset purchases – suggesting that new ECB Chief Christine Lagarde will allow time for recent measures to feed through into the Eurozone economy before acting. We do not expect the ECB to need to cut rates further, implying rates will remain on hold as well. We believe that criticism of the negative rate policy will only grow, and we could even see Lagarde take a more “Swedish” approach later in 2020 and rethink negative rates.
The Bank of Japan has maintained a dovish tone, though we believe it is running out of ammunition and will therefore not ease further. The Bank of England is awaiting clarity on Brexit before acting, though we expect this to be somewhat sorted early in 2020. As such, the BoE should not need to act, though recent data has highlighted the fragility of the UK economy, suggesting rate cuts cannot be excluded. Emerging market central bankers have been cutting rates, taking advantage of a more accommodative Fed to cut without weakening their currencies too much. We expect this trend to continue, and expect cuts combined with fiscal easing where possible.
In all of these scenarios, possibly with the exception of the Fed, we expect central bank heads to increase pressure on their governments for fiscal easing in addition to monetary support. In Europe in particular, we believe that monetary policy will not suffice to jump-start the Old Continent, though we believe much-needed fiscal help will be hard to come by. We do expect Lagarde to reach for such measures with more insistence than her predecessor.
Global Interest Rates over 10 Years
Source: Bloomberg, Natixis Investment Managers Solutions, November 26, 2019
As we have seen in recent years, it has become increasingly difficult to “predict” where rates are going. As such, we believe that the bigger call is whether rates will be higher or lower at the end of next year. In our view, yields are likely to continue to gradually drift higher on better geopolitical developments and the ensuing optimism. However, we believe that yields will likely remain contained given lingering growth concerns – we remain advanced in the cycle and growth worries are likely to persist, even if just for 2021. In addition, inflation remains low and central banks accommodative, reducing the risk of a sharp move back up. Risks remain, and while we remain optimistic on the outlook, we do not expect much in terms of market performance. That being said, we believe that US 10-year Treasury yields will be above 2% with our base case scenario.
Credit metrics remain healthy, and we continue to believe that credit will outperform sovereigns. Yes, leverage levels have risen, but interest cover ratios remain healthy, both in the US and in Europe, and valuations are more attractive. As such, we see some room for credit spreads to absorb somewhat higher yields. We believe that demand for investment grade will continue as we advance in the cycle, but believe that there are opportunities in high yield given central banks’ support and better growth prospects. Default rates are expected to rise, but within norms, and we do not see any systemic risk for now.
10-Year Government Bond Yield
Source: Bloomberg, Natixis Investment Managers Solutions, November 26, 2019
Equity markets should benefit from improving sentiment thanks to optimism on encouraging geopolitical developments, but we do not expect performance to follow much beyond that. Most of the recent rally has come from multiple expansion, and valuations are rich – if not stretched, though less than sovereign debt. In the US, the S&P 500® P/E, at 17.6, is above average (16 over past 7 years), while the Nasdaq is at its high (23.7). Europe indices are right in line with longer-term averages (14.5), and the MSCI Emerging Markets index is just above, but none can be considered cheap other than the UK. We expect some earnings growth in 2020, but earnings growth may have peaked already, suggesting little support for next year. Margins have been squeezed due to tariff increases, and while this may improve somewhat, we do not have too-high expectations. As such, we expect positive performances, but nothing stellar.
We believe that Europe should benefit from increased risk appetite, better growth prospects and higher rates, but how long this advantage lasts is a question given little upside in yields in our view. The US should continue to do well given higher growth and earnings, though valuations are richer and could cap performance. Emerging markets have room to catch up, but still face some hurdles – including plenty of social unrest, even if global growth and trade improve in 2020.
We paint a relatively optimistic picture of 2020, though without very strong performances as a result, given the current starting point. However, risks remain. As mentioned above, the biggest opportunity is also the biggest risk to our outlook: trade. Trump’s unpredictability, China pushing for too many concessions, Hong Kong unrest – any of these could lead to a breakdown in talks and progress.
The same can be said with Brexit, where polls have been proven unreliable. US politics are likely to remain in the spotlight given the upcoming elections, and the ongoing impeachment proceedings could add volatility – though we still do not expect any impact unless Republicans turn on the president. Finally, Italian politics can come back to the fore, as the governing coalition looks increasingly fragile.
If geopolitical developments continue to improve, with easing trade tensions and reduced uncertainty, the 2020 outlook should be relatively optimistic. However, we remain in a complex environment and we do expect stellar market performances. As such, we continue to add flexible, absolute return strategies, such as liquid alternatives, in order to complement traditional asset classes. We also look to less-liquid strategies to boost yield, as we expect rates to remain low for longer, extending a difficult search for yield. As we move forward in the cycle, even if we believe it will extend further still, we maintain some core assets as protection, and believe that, more than ever, active management is key.
MSCI Emerging Markets Index is an unmanaged index that is designed to measure the equity market performance of emerging markets.
S&P 500® Index is a widely recognized measure of US stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.
Equity securities are volatile and can decline significantly in response to broad market and economic conditions.
Fixed income securities may carry one or more of the following risks: credit, interest rate (as interest rates rise bond prices usually fall), inflation and liquidity.
Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.
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This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of November 26, 2019 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.