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Three reasons to invest in Europe, and three reasons to avoid it

9 April 2019

Nikki Howes, investment associate at Heartwood Investment Management, looks at the current picture and assesses what it means for investors in Europe

Economic momentum stalled in 2018, with many investors increasingly concerned about slowing European growth. Italy entered technical recession (two consecutive quarters of negative growth) and Germany only missed it by a whisker.

In 2019 so far, European economic data has been decidedly mixed, with the manufacturing picture worsening further while the service sector has held up relatively well. What does all of this mean for investing in Europe today?

Reasons to invest

1. Currency weakness is good news for exporters. The euro has been weakening against the dollar since mid-2018. Europe exports more than it imports, meaning that its exporters can benefit from this weaker currency as it increases the value of their foreign earnings in euro terms. In the past, euro weakness has tended to correlate with a rising stock market in Europe, but this rise typically lags currency weakness as it takes time to show up in reported company earnings. As a result, the euro weakness experienced last year should now be good news for the stock market in the near term. Supportive language from the European Central Bank in March has resulted in a further drift down in the currency, which should continue to benefit European stocks.

2. One-off issues are fading. Some of last year’s European stock market weakness can be attributed to a confluence of one-off events, from new emissions testing regulations and abnormally low Rhine river water levels in Germany to Italian budgetary woes and populist protests in France. These factors and their effects have begun to subside, which could prove positive for European stock markets. The growth backdrop in 2018 may also have been impacted by reports of manufacturing companies de-stocking after accumulating large inventories in 2017, but survey data suggests stock levels are now back to desired levels, potentially removing another constraint on growth.

3. Low unemployment is supporting wage growth and spending. Unemployment in Europe is close to historic lows, putting upward pressure on wages and helping to support household spending. More importantly, the direction of travel is towards continued strengthening: unemployment has not risen once since 2014.

Reasons to avoid

1. Potential auto tariffs pose risks to growth. With trade talks between the US and China apparently heading towards a conclusion at last, it is possible that President Trump will now turn his attention to fighting another trade battle, this time with Europe. Auto tariffs have already been threatened, although Europe has been quick to note that it would retaliate, and in any case there appears to be little support in US Congress for the tariffs. However, risks remain for the European auto sector, particularly with an unpredictable president who has made no bones about his dislike of Europe’s trade surplus with the US.

2. A slowing Chinese economy would have knock-on effects. Europe is not immune to slowing growth abroad, particularly in China, and this has been most evident in European manufacturing sector declines as Chinese growth falters. The Chinese government has taken steps to support its economy, but the benefits have yet to show up in hard economic data. A continued slowdown in China would certainly hinder European growth prospects, which in turn would spell bad news for European stock markets.

3. The shadow of Brexit cannot be ignored. The UK and Europe enjoy famously close economic ties, and the EU bloc is the UK’s largest trading partner. A hard Brexit (which at the time of writing remains a possibility) would be markedly detrimental to an already fragile European economy.

How should investors respond?

Overall, we believe the domestic European picture continues to look relatively healthy, with positive labour markets and the potential for exporters to benefit from a weak home currency. We are also encouraged by signs that some of Europe’s previous hindrances to economic health are fading. Nevertheless, given recent deteriorating economic data and a lack of clarity around the effects of Brexit and a slowing Chinese economy, our portfolios maintain neutral exposure to European stock markets.

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