Europe at a crossroads: Recession or turnaround?

By Tilmann Galler, 14 Feb 2019

Since the start of 2018, the European economy has continued to disappoint investors. A multitude of factors, both external and domestic, have contributed to a backdrop of slowing economic growth. A revival in growth in China is the most likely catalyst for a turnaround—but perhaps later in the year.

“With limited help available to the eurozone economy from within, an improvement in external factors might prove the key for a turnaround.”

Tilmann Galler

There was a lot of promise and expectation for European growth at the start of 2018. Fuelled by easy financial conditions and falling unemployment, the European recovery looked to be finally finding its feet.

However, since then, economic data for the region has deteriorated significantly. As this weakness has persisted, investors have become tired of the seemingly perpetual excuses for weak data, and sentiment towards European assets has worsened. With few domestic catalysts for a turnaround, it may take a rebound in demand from the emerging world to improve prospects for the region.

What has gone wrong for the European recovery?

Looking at the detail of the slowdown, it appears that much of the weakness can be attributed to net exports. Net exports contributed 1.4 percentage points to the annual real GDP growth rate in the fourth quarter of 2017, but in the third quarter of 2018 their contribution was negative. Both sides of the equation-imports and exports-contributed to the deterioration, as the rising oil price in the first three quarters of 2018 led to a sharp increase in imports, while at the same time export growth stalled.

Given that exports make up approximately half of GDP in the eurozone, a slowdown in global growth was always going to prove a strong headwind. In particular, demand from emerging markets has softened. In November, exports to Turkey contracted by one-third year on year due to the confidence crisis that led to a slowdown in growth and the devaluation in the currency, while export growth to Asia slowed because of a slowing Chinese economy.

But external factors aren’t the only ones to blame: domestic factors have played their part too.

In Italy, the new coalition government’s dispute with the European Commission over its proposed budget sent borrowing costs to multi-year highs and tightened credit conditions. The prolonged period of political uncertainty has taken its toll on the Italian economy, with the country technically falling into recession.

In France, the protests of the “gilets jaunes” (a movement focused on social inequality) have caused significant disruption, sending the French composite purchasing managers’ index into contractionary territory at the end of 2018. Impetus in the protests now seems to be waning and growth data for the fourth quarter of 2018 held up surprisingly well. But populism remains a risk across Europe, with the European Parliament elections in May likely to show that Eurosceptic parties still garner significant support.

In Germany, the autos industry has struggled to get to grips with the new emissions testing regulations, hampering industrial production and dragging significantly on growth. After a difficult fourth quarter of 2018, German auto production now looks to be picking back up (Exhibit 1), which could be a near-term boost to growth.

EXHIBIT 1: GERMANY NEW CAR REGISTRATIONS

% change year on year, three-month moving average


Source: KBA, Refinitiv Datastream, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data as of 31 January 2019.

What could be the catalysts for a turnaround?

The European consumer is still fundamentally well supported as the unemployment rate continues to fall and wages pick up. In addition, the oil price has fallen significantly since October last year, serving in effect as a significant tax cut for European households. Historically, there has been a close inverse relationship between the oil price and consumption in the region, suggesting that the recent move in oil can help to boost consumption (see Exhibit 2). The fall in the oil price will also help European businesses by easing cost pressures.



Source: Bloomberg, Eurostat, Refinitiv Datastream, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Guide to the Markets - Europe. Data as of 31 January 2019.

Monetary policy looks set to remain accommodative in 2019, which will keep lending rates at a very supportive level. The European Central Bank (ECB) reiterated its forward guidance on interest rates in January, and also acknowledged that the risks to the outlook had moved to the downside.

Attention is quickly turning to what the ECB could do to provide further stimulus. In the near term, this may involve further liquidity assistance through its Targeted Long Term Refinancing Operation II initiative (TLTRO II) —a EUR 700 billion programme launched by the ECB to incentivise eurozone banks to lend to non-financial corporations and households, by lowering the banks’ marginal borrowing costs. Italian and Spanish banks currently hold the largest chunk of the loans (60% of total volume). This policy measure is starting to come into focus again as these loans will begin to mature in June 2020. At a minimum, we would expect the ECB to announce an extension of the initiative to continue to provide support to the banking sector and economy.

Beyond this liquidity provision, the ECB’s ability to stimulate the economy further is limited. Key interest rates are already in negative territory. The ECB will struggle to expand quantitative easing as it is nearing the upper limit of the amount of German Bunds it is permitted to buy. Parameters would have to shift to allow it either to buy a larger proportion of the German market, or more debt from other countries—a politically contentious issue.

On the fiscal side, we are seeing governments move to incrementally looser policies—notably in Italy and France. But these countries will ultimately be constrained by their already high public debt-to-GDP ratios, which sit at 132% and 99%, respectively (vs. the 60% limit set out in the EU’s Stability and Growth Pact). Germany has fiscal capacity for significant stimulus, but the political appetite appears limited.

With limited help available to the eurozone economy from within, an improvement in external factors might prove the key for a turnaround in sentiment among both manufacturers and consumers. The necessary catalyst for a change in economic momentum could also come from the avoidance of a hard Brexit, a de-escalation in trade tensions or a soft landing in China. While the first two carry the imponderabilia of politics, we have a larger degree of confidence in the latter as China continues to ease monetary and fiscal policy to stimulate its economy. In January, the People’s Bank of China cut its Reserve Requirement Ratio by a further 100 basis points, injecting a net figure of RMB 800 billion (0.8% of nominal GDP) into the Chinese economy. New infrastructure projects have also boosted investment growth, and Beijing continues to implement tax cuts for corporates and consumers alike.

Eurozone stocks may perform better than the economy

The multitude of elements that have contributed to a slowdown in Europe, coupled with the absence of a clear catalyst for a turnaround, has left investors cautious of investing in the region. But it is worth remembering that approximately 50% of European corporate revenues come from outside the region. In 2018, the European macroeconomic environment continued to deteriorate, but companies were still able to achieve a respectable 5% earnings growth. An uncertain economic outlook for the region suggests investors should remain cautious in the near term. But the international nature of European companies and the broader eurozone economy means that the direction of the global growth environment will have a large bearing on future performance. Investors will likely stay on the sidelines in Europe until we get the promise of a lasting recovery in growth. But were the macro data to improve we could see a change in fortunes for European stocks given a lot of bad news is in the price.

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The Market Insights program provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients understand the markets and support investment decision-making, the program explores the implications of current economic data and changing market conditions. For the purposes of MiFID II the JPM Market Insights and Portfolio Insights programmes are marketing communications and are not in scope for any MiFID II/MiFIR requirements specificallyrelated to investment research. Furthermore, the J.P. Morgan Asset Management Market Insights and Portfolio Insights programmes as non-independent research have not been prepared in accordance with legal requirements designed to promote the independence ofinvestment research; nor are they subject to any prohibition on dealing ahead of the dissemination of investment research.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designedto be as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, noris it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support aninvestment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their ownprofessional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure thatthey obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given andnoliability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the incomefrom them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields is not a reliable indicator of current and future results. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.

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ETF currency hedging strategies

Static monthly hedge

  • Monthly reset reduces transaction costs.
  • Consistent with many index methodologies, which may reduce tracking error.
  • Imperfect hedge may leave investors with unexpected currency risk.

Static daily hedge

  • Daily reset increases transaction costs.
  • Consistent with many index methodologies, which may reduce tracking error.
  • Daily reset minimises currency risk, however high transaction costs can outweigh benefits.

Tolerance-adjusted hedge

  • Hedges are reset whenever hedge ratio breaches pre-set threshold, resulting in lower transaction costs than daily hedging.
  • Difficult for index providers to reflect in index methodologies, which may increase tracking error.
  • Removes more currency risk than monthly hedging while reducing transaction costs compared to daily hedging.

Spotlight on hedge ratios

To achieve a 100% hedge ratio, the value of the derivatives used to hedge a portfolio’s currency exposures should equal the notional value of the portfolio’s assets.

If the value of the portfolio’s assets rises, the hedge ratio will fall and the portfolio will be under hedged.

If the value of the portfolio’s assets falls, the hedge ratio will rise and the portfolio will be over hedged.

If hedge ratios become too stretched there is a risk that the impact on the performance of one hedged share class could impact another share class of the same fund.

Regulatory measures require ETF providers keep hedge ratios within a 95%-105% tolerance, making a tolerance-adjusted hedging model appropriate for many ETFs.