Eurozone Risks Overstated

Originally published by AMP Capital h2 Investment markets and key developments over the past week/h2

• Most major share markets continued to move higher over the past week helped by more good economic and profit news and anticipation of President Trump’s pro-business policies. Bond yields generally rose as the reflation trade continued but commodity prices were mixed with oil and metal prices down a bit but the iron ore price surging higher. The Australian dollar rose a bit presumably helped by further gains in iron ore prices and slight falls in the US dollar.

• The resignation of President Trump’s National Security Adviser Mike Flynn and the ongoing investigations into links between Trump’s campaign and Russia highlights the political risks around this unusual Administration. But as long as Trump continues on the path to implementing his pro-business agenda and assuming Trump himself is not implicated it’s just ongoing noise that investors have to get used to.

• The focus on Eurozone break up risk is continuing to hot up with elections approaching in the Netherlands on March 15, France in late April/May and Germany in September. Our view remains that such risks are overstated, but any related market panic should provide an opportunity for investors. Looking at each in turn, based on current polling:

• The populist Euroskeptic Party for Freedom will get more than any other party in the Dutch parliamentary elections, but at around 30% of the vote and seats won’t be able to form government, with that likely to come from some combination of roughly ten centrist parties.

• Similarly Marine Le Pen whose policy is to leave the Eurozone will “win” the first round of the French presidential election with around 25-30% of the vote but will lose the second round to either the Republican Party’s Francois Fillon (by 15-20%) or more likely to the independent Emmanuel Macron (by 20-30%). Both Fillon and Macron are economic reformists which is exactly what France needs.

• It’s a long way away but, German Chancellor Angela Merkel is at some risk of losing to the centre-left Social Democrat Party whose new leader Martin Schulz is polling well. But Schulz is more pro Europe than Merkel so even if he does win it could actually mean a stronger Eurozone as he and the SPD are likely to end austerity in favour of some German fiscal reflation (which could help both Germany and peripheral Eurozone countries). The populist Alternative for Deutschland seems to stuck at around 10% support.

• Ahhh, you say – but what about Brexit and Trump? Surely there is a risk of a populist upset. Yes there is – particularly in the Netherlands or France. But the polling against a populist forming government in these three countries is far more decisive than was the case prior to the Brexit vote and US presidential election (where the polling was actually very close). More fundamentally it can be argued that Europe is different. Support for the euro remains high and inequality is far less of an issue in most of Europe than in the UK or the US. And an abatement of the migration crisis is helping too.

• Perhaps the country at greatest risk is Italy but even here if the Eurosceptic Five State Movement wins in their next election (possibly this year) it is likely to end up going down the path of Greece’s Syriza which has become just another European centrist party after it realised the cost to Greece of exiting the Euro. Speaking of which Greece is at risk again facing tough negotiations with its creditors. These will probably be resolved but even if not and an early election ensues it’s noteworthy that the pro-euro pro-reform New Democracy party is polling well.

• The bottom line is that Eurozone break up risks are overstated and if they intensify in the months ahead hitting Eurozone shares, bonds and other assets it should be seen as a buying opportunity.

• US economic data continues on the strong side with a solid gain in retail sales, small business confidence remaining strong, very strong readings in the New York and Philadelphia regional manufacturing conditions surveys, continued strength in home builder conditions, strong readings for housing starts and permits and continuing ultra-low unemployment claims . Meanwhile, core consumer price inflation edged up more than expected to 2.3% year on year. Fed Chair Janet Yellen’s Congressional testimony on the rates front provided nothing new signalling an intention to make haste gradually in raising rates this year and that all coming meetings are live for the next move providing the data behaves as expected. Our base case remains that the next hike will be in May or June but the past week’s run of strong data points to a rising risk of a March hike (with the market current putting the probability of such a move at 36%.) 80% of US S&P 500 companies have now reported December quarter profits with 74% beating earnings expectations with an average surprise of +2.6% and 52% beating on revenue.

• Japanese December quarter GDP growth disappointed at 0.2% quarter on quarter or 1.6% year on year. But it marked four straight quarters of positive growth and business conditions indicators point to some acceleration ahead.

• Chinese consumer and producer price inflation rose more than expected in January and combined with a surged in credit underpin the PBOC’s move to gradually tighten monetary policy. While a range of infrastructure projects should support growth in the near term and the Chinese Government is unlikely to allow growth to slow much, the move to policy tightening and threat to growth will no doubt worry investors at some point later this year.

• Australian economic data was good with a further gain in business conditions and confidence in January according to the NAB survey, a rise in consumer confidence to around its long term average, stronger than expected jobs growth in January and a fall in unemployment. The main drag was a return to weakness in full time jobs highlighting that the quality of jobs growth remains poor. This is partly structural reflecting the growing importance of the services sector in the economy and its preponderance towards part time jobs but it’s also partly cyclical and on this front it’s worth noting that job vacancies and business employment plans point to stronger employment growth ahead which should help full time jobs.

• Another big positive is the ongoing rise in the iron ore price which broke $US90/tonne in the last week for the first time since 2014. Softer structural growth in China and stronger supply warn this is not the start of a re-run of last decade’s commodity boom. But its neverthess a big positive for national income in Australia. The iron ore price at $US90 if sustained will add around $9bn annually to Federal taxation revenue.

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• At this stage our view remains that the RBA will cut rates again this year as inflation takes longer to move back to target. But if the positive news on growth and national income continues at a time when the Sydney and Melbourne property markets remain too hot then we will have to concede that the next move in rates is up – albeit not till later in 2018 – rather than down.

• We are now a bit over 40% through the Australian December half profit reporting season. As is often the case after an initial flurry of good results we have seen a few more misses over the last week. But so far the overall results remain good. 53% of companies to report so far have exceeded earnings expectations compared to a norm of 44%, 70% of companies have seen profits up from a year ago and 69% have increased their dividends from a year ago. But reflecting the strong rally in the market in anticipation of the results only 44% have seen their share price outperform the market on the day they reported as a lot of good news was already priced in. Resource profits are on track to more than double this financial year and this is driving a return to overall profit growth for the market.