A European cyclical upswing might challenge investors

April 30, 2019 12:22
British companies don’t want to commit to expand capex until there is more clarity on the Brexit arrangement. Photo: gov.uk

Investors' sentiment towards the euro area remains extremely negative. Short positions in European equities are considered the world’s “most crowded trade”, according to a recent edition of the Bank of America Merrill Lynch Global Fund Manager Survey. Economic data continues to disappoint already depressed expectations and there is no shortage of geopolitical risks on the horizon. European Central Bank President Mario Draghi again highlighted that risks to the growth outlook were tilted to the downside. As a result, German 10-year bond yields dipped back to below zero.

The slowdown in the euro area over the past year can be explained to a large extent by the slump in world trade and manufacturing activity. This in turn reflects sluggish growth in China following the deleveraging campaign that started in 2017. Asian demand for euro area goods and services accounted for 40 percent of total euro area exports growth in 2017. But at the end of last year, exports to the region contracted on an annual basis.

Other idiosyncratic factors have helped depress external demand. The balance of payment crisis in Turkey has led to a sharp contraction of European exports to the country. And uncertainty around Brexit has forced companies to put investments on hold, depressing demand for euro area capital goods.

There are signs that weaker external demand has also started to weigh on domestic investment via manufacturing supply chains. New orders of German capital goods from euro area corporates declined by 14 percent year on year in February, the most since 2012 and by a much larger margin than those from other foreign firms.

Investment intentions have fallen steadily over the past 12 months and are back to their long-run average. And according to the ECB’s recent bank lending survey, corporate demand for credit stagnated in the first quarter of this year as there was less of a need to fund working capital.

Consumption has continued to grow at a healthy pace, however, as robust employment creation and stronger wage growth have supported disposable income. This goes some way to explaining the relatively good performance of the services sector. Still, employment intentions have been deteriorating for several months, suggesting that consumption is likely to be affected if the growth slowdown persists.

As we have been arguing recently, there is growing evidence that the slump in the global manufacturing cycle will soon reach a trough. There are already signs of life in Asian supply chains – exports rebounded in March – as China’s economy begins to feel the benefits of a looser policy.

This should eventually prop up activity in Europe. The turn in the inventory cycle in Sweden in recent months supports this view. Growth in Turkey – and hence the pace of imports from the euro area – is unlikely to weaken much further.

Finally, the six-month delay to Brexit shows there is no appetite in European capitals for a disorderly exit. As we made the case previously, the only deal that can muster the approval of the UK parliament is one that envisages a closer future relationship. British companies won’t want to commit to expand capex until there is more clarity, but investment should not weaken much further. At the margin, this should help euro area exporters.

In addition, fundamentals are in place for an investment rebound if global growth stabilizes. Indeed, unlike in 2012 or 2015, capacity utilization in the euro area is high with both physical capital and labor as important limits to production. This also means that the strong pick-up in wage growth should eventually feed through to prices as firmer demand would allow corporates to restore some of their profit margins.

Given how investors are positioned, even a slight improvement might be enough to push bond yields and growth stocks higher.

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International Economist, Bank J Safra Sarasin