While economic activity is likely to recover slowly in the euro area, I believe the risk of a much worse outcome has abated. Improved macroeconomic policy should lead to a stronger recovery, driving further reductions in the valuation gap between US and euro-area stocks.
The COVID-19 crisis has caused a deep recession in the eurozone, and I don’t expect activity to return to end-2019 levels until mid-2022. A recession of this magnitude leaves many kinds of economic scars. Jobs and businesses are destroyed, and the necessary reallocation of labour and capital is expensive and takes time. Balance sheets are damaged as a result of falling incomes, and the continued uncertainty constrains investment and consumption.
On the plus side, I believe Europe’s management of the health crisis and the economic policy response have been strong enough to substantially reduce downside risks to both economic and earnings growth compared with three months ago.
As a result, I believe that the euro-area economy will recover more strongly than it did after the global financial crisis (GFC). The main reason is that European macroeconomic policy has improved. Monetary policy will remain supportive, with massive purchases of sovereign assets, while expansive domestic fiscal policy and financial sector policies should encourage credit growth and spending.
The recently announced EU recovery fund reinforces those effects, because it creates a joint fiscal capacity, provides support for investment and distributes funds to the periphery. It is also a strong positive political statement about how the EU handles crises. In the aftermath of the GFC, the euro area tightened fiscal policy and forced private-sector consolidation too early in the recovery — an error that now looks unlikely to be repeated.
As for the pandemic, the number of cases is rising in Europe. While I acknowledge the downside risks to my view, I am not expecting this resurgence to lead to further large lockdowns. Rather, I foresee continued but smaller-scale restrictions of activity.
What does this mean for markets?
If my predictions are right, I think the implications are:
Higher nominal growth and inflation expectations — Negative demand effects dominate now, but the destruction of jobs, the costly reallocation of labour and lower internal migration will lead to reduced capacity in the coming years. As demand recovers, I expect those capacity constraints to fuel higher inflation.
Lower risk premia — Despite the recovery in inflation expectations and risk assets, I expect risk premia to fall further, reflecting the reduction in political and macro downside risks. As we emerge from the COVID crisis — late this year and early next — I would expect a small further rise in inflation expectations, higher real bond yields and rising nominal yields. While this is a reflation story, real growth remains modest, and the upside risk to inflation expectations and nominal interest rates is limited by the continued need to keep real rates low.
A further reduction in the valuation gap between US and euro-area equities — Given the change in the relative COVID risks and growth and political outlooks, I remain upbeat on euro-area equity valuations compared with the US. Euro-area equities have underperformed US equities consistently since the GFC. While they started outperforming in the late spring of this year, they remain a long way from the sustained outperformance in the periods after the 2001 recession and the GFC.
How much of that valuation gap reflects Europe’s lack of equivalents to the US tech stocks and globally dominant companies? While these factors may explain some of the discrepancy — the performance gap against the world ex-US is much smaller — I believe a large macro-driven differential remains, reflecting depressed nominal growth expectations, low interest rates and policy/political uncertainty. Better growth, reduced risk premia and, crucially, a steeper nominal yield curve could help to close the gap.
I still expect value stocks to outperform growth and cyclical stocks to outperform defensives. I also think European banks and other financials should perform well.
Euro appreciation versus the US dollar — I expect the euro to strengthen. However, any sudden rise would present a policy problem and could put downward pressure on euro-area equities.
There is always scope for mishaps… The COVID crisis could worsen further; policy could be tightened prematurely after all; and the current political agreement on the recovery fund could unravel.
…and Italy remains a risk. Italy’s recovery looks much better than I feared, and the political environment appears relatively robust. But, with a debt-to-GDP ratio above 150, large upfront funding requirements and weak growth, a resurgence in Italian fiscal risk is always possible.