European stocks have finally offered investors a positive surprise, and Italy has led the way.
The country’s benchmark equity index, the FTSE MIB index, has climbed 17 per cent this year and is up 42 per cent over the past 12 months. The gains are even more marked when calculated in dollar terms.
Having seen off populist threats in France and the Netherlands earlier this year, the eurozone economy is enjoying its fastest growth in six years and luring money from foreign investors more accustomed to seeing the bloc wrestle with existential threats.
With polls suggesting German voters will on Sunday return Angela Merkel for a fourth term as chancellor, investors can hope that Europe’s most experienced leader and France’s young president Emmanuel Macron will consider ways to inject new life into the eurozone project.
“This is the first time I can remember we’re talking about the construction of Europe when not in a crisis,” enthuses Bastien Drut, fixed-income strategist at the French asset manager Amundi. “Something has definitely changed after Macron’s election.”
Mr Macron is set to make a big speech on Tuesday laying out an ambitious set of reforms for the Eurozone, in an attempt to force Berlin to shift ground on its approach to the single currency.
While a potential Merkel-Macron axis is a more encouraging backdrop to the overwhelming fear at the start of the year that far right leader Marine Le Pen could capture the French presidency, its immediate impact on markets will be limited, according to Guillaume Menuet, director of European economics at Citi.
“It’s GDP growth surprises and the monetary policy stance of the European Central Bank which is going to be a much bigger driver of asset prices,” he says.
It is the scale of the economic improvement that has helped convince investors to bet on the eurozone. The 19-country currency bloc recorded year-on-year growth of 2.3 per cent in the second quarter. According to European Central Bank figures published this week, non-residents bought €61bn of eurozone equities in July, the highest monthly amount since November 2012.
And the eurozone’s economic momentum has helped make Italy the market’s outperformer.
“When you have accelerating economic growth in the Eurozone, it’s negative for the relative performance of the UK and Switzerland but it’s good for Italy and Spain because of their heavy concentration in financials,” says Sebastian Raedler, head of European equity strategy at Deutsche Bank.
He says he was “overweight Italy until a month ago,” but like other institutions, Deutsche now favours German stocks. The German Dax is up 9.9 per cent this year and France’s CAC 40 index has climbed 8.4 per cent.
While the Euro Stoxx 600 index, the main European benchmark that includes the UK and Switzerland, has surged 20 per cent over the past 12 months, it has fallen 6 per cent since Mr Macron‘s election victory.
A stronger euro has helped take the shine off the market’s performance, and there is disagreement over where it goes from here. Barclays has a target of 400 for the Stoxx 600 by year end, a 5 per cent rise from the current level. Christopher Potts of stockbrokers Kepler Cheuvreux says markets could rise to levels last seen in 2000.
However, Mr Raedler at Deutsche is more cautious. “European stocks have already fallen from peak in early May as a consequence of a stronger euro, geopolitical concerns and fading macro momentum. We expect the tactical pullback to continue to around 360 on the Stoxx 600.”
The appreciation of the euro this year is among the major concerns, alongside an expected change in monetary policy as the European Central Bank begins to scale back its asset-purchase programme.
It is estimated that a little more than 50 per cent of European companies’ sales are outside the Eurozone. In Germany, with its preponderance of exporting Mittelstand companies, that figure is higher.
Although euro strength usually has a negative correlation with the region’s equity markets, the sensitivity to the stronger single currency varies across sectors. Consumer staples and healthcare are among the most exposed, while financials, utilities, and telecoms the least vulnerable.
Caroline Simmons, deputy head of the UK investment office at UBS, says if the euro stays around current levels, it would represent a drag on earnings of about 2-3 per cent. But she adds: “Headwinds from the currency should be more than offset by the improved earnings picture.”
One anxiety is if the currency overshoots to levels of $1.35 or more, which companies say is when it starts to hit the competitiveness of their exports. The exchange rate is currently about $1.19, and has appreciated by 13 per cent against the dollar this year.
Didier Saint-Georges, managing director of Carmignac, France’s largest independent asset manager with €61bn under management, says investors would be “well advised to stay in cyclical stocks, value stocks, even financials”.
Apart from a short period after the financial crisis when valuations converged, Europe’s markets remain cheaper than the US, with price-earnings ratios stable as earnings have improved. That offers encouragement to those who are bullish that the European market can add to gains.
Giuseppe di Mino, managing director of hedge fund Amber Capital, believes the biggest change in market sentiment is that no one is any longer talking about possible eurozone break-up.
“Where the currency is going to be, that is not the question. As long as there is stability in the eurozone, and a clear direction for the European project, we think corporates will continue to be optimistic.”
Anything that the Macron-Merkel axis can deliver is likely to be counted as a bonus by investors.