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Investment Times

Five reasons to be positive on Europe

| 27 February 2015 | A A A
Five reasons to be positive on Europe

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No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

While the European economy is widely viewed with caution by investors, there are signs that a recovery could be around the corner. The latest figures showed the euro zone economy grew by a better-than-expected 0.3% in the final quarter of 2014, buoyed by 0.7% growth in its largest constituent, Germany.

However, it's easy to see why investors are pessimistic about Europe. This week Italy became the latest country to enter deflation, with prices falling 0.6% in the year to January. Italy joins fellow euro zone members Belgium, Germany, Greece, Ireland, Portugal and Spain in this club.

Meanwhile economic growth is slow in most nations, while underlying structural problems such as poor demographics, high debt levels and an inflexible labour market are yet to be resolved.

No recommendation

No news or research item is a personal recommendation to deal. All investments can fall as well as rise in value so you could get back less than you invest.

These problems are well-documented, and combined with ongoing political tension between the euro zone's core and its periphery, have depressed investor sentiment towards Europe to extraordinarily low levels.

Yet the latest growth figures are the latest in a series of signs the economic climate might be improving, and the European Central Bank's quantitative easing programme might therefore benefit from a following wind.

1. The credit cycle might finally be turning

After two and a half years of contraction, euro zone bank lending to the private sector is growing again. The figure is only 0.1%, but could nevertheless represent a turning point. The latest ECB survey of credit conditions also showed a marked improvement in credit demand in the region. The finer details are also promising: lending to non-financial companies was up €11.3bn in December, the largest increase since 2011. The money supply is also increasing - currency in circulation and overnight deposits up 7.8% year-on-year; this usually bodes well for economic growth.

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2. A weaker euro should boost exports, but also help domestically-focused firms

A weaker currency makes exports cheaper to foreign buyers. This will aid the euro zone's crucial export sector, especially in countries like France and Italy where euro strength had caused many firms to struggle. There are signs this is starting to happen already as the euro has weakened over the past year - see chart below.

At the World Economic Forum in Davos, Italian Prime Minister Matteo Renzi said that he would like to see the euro weaken further, towards parity with the US dollar.

The effect on exports is well-known, but often overlooked is the impact on domestically focused firms. A weaker currency helps here too, as it makes imports comparatively less attractive and therefore lessens competition from overseas.

Euro zone - exports vs exchange rate

3. Germany is leading the way once more

Cast your mind back to the first throes of the euro zone crisis, and the concerns centred on the peripheral nations like Greece, while core economies such as Germany remained in relative good health. It was a shock, therefore, when last autumn German economic sentiment indicators turned negative, and it was revealed that the euro zone's largest economy had contracted in Q2. Now, however, German data is on an upward trend again - unemployment recently fell to the lowest level since reunification, and consumer confidence hit a fourteen-year high. Latest figures show the German economy expanded 0.7% in the final quarter of 2014, boosted by growing exports, consumer spending and business investment.

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4. Some peripheral economies look to be out of the woods

The PIIGS have been reduced in number and are now the IGS. Both Portugal and Ireland have 'taken their medicine', cutting government spending hard to sort out their public finances. They have exited their bailout schemes and are now growing strongly. Ireland is now the euro zone's fastest growing economy. After being bailed out in 2010, Ireland is expected by the EC to have expanded by 4.6% in 2014. Its budget deficit is shrinking, and should fall to 2.9% in 2015.

5. QE should stave off deflation

The jury is still out on the effectiveness of QE. One thing we do know is that it is likely to boost stock markets, but its effects on the economy are less clear. A Bank of England study suggests QE in the UK did little to increase bank lending, and it certainly won't deliver the structural reforms the euro zone so badly needs. However, QE should at least convince markets that Mario Draghi is committed to fighting deflation. If markets and the public are confident that inflation will return to the ECB's target, it could become a self-fulfilling prophecy. Furthermore, if the early months of QE coincide with a cyclical recovery (for the reasons described above), it would reinforce the positive impact QE has already had on confidence and inflation expectations.

Negative sentiment towards Europe is rife, but a look beneath the surface reveals definite signs the tide might be turning. This means investors have an opportunity. The negative economic outlook has depressed share prices to bargain levels - if the data keeps showing improvement, sentiment could improve from rock-bottom levels. Combined with the boost that quantitative easing looks likely to provide, I believe this could be a potent mix for share prices.

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