A massive monetary stimulus is much needed as the eurozone remains under huge stress even though it somehow managed to dodge entering a recession in the third quarter. In November, the purchasing managers' index, compiled by data firm Markit, fell by more than a point to 51.1, slightly above the critical 50 level that marks an expansion in activity. This is the lowest reading since July 2013.
The data emerging from the eurozone's three economic powers certainly paints a dire picture. Europe's economic powerhouse, Germany, has stalled - the impact of which will be felt across the region as the country accounts for 25 per cent of the total population of the eurozone, as well as 27 per cent of its GDP. Earlier this month the Bundesbank cut its 2015 GDP growth forecast in half to just 1 per cent.
Although German policymakers highlight the geopolitical tensions in eastern Europe as the reason for the modest contraction in German GDP in the second quarter, economists at JPMorgan Asset Management point out that Russia accounts for just 6 per cent of German exports. They note that weakness in key export markets such as France and Italy is likely to have been a more important factor pulling down exports in the past few months.
L'économie est horrible
Indeed, the second-largest economy, France, accounting for €2tn, or a fifth of the eurozone’s economy, is battling with high and rising unemployment, subdued domestic demand, growing public debt, an excessive budget deficit, and the deeply unpopular socialist government of François Hollande which remains hell-bent on pushing through €50bn of austerity cuts by 2017.
In fact, the country is once again suffering one of its all too common crises. Marine Le Pen's far right and anti-Europe National Front Party became the first political party in France to gain a quarter of the votes at the European elections, while the popularity of the president is at the lowest level ever seen in the Fifth Republic. It's not just in the eyes of the voters either: disagreements between François Hollande and the leftists of his own party have led to two government reshuffles since March.
If that was not enough to contend with then the ability of the Socialist Party to revive the economy is being hindered by popular resistance to any attempt to introduce reforms (air traffic control and rail workers went on strike this year, for instance) and by an excessive budget deficit (3.9 per cent of GDP) which has meant France is under the supervision of the European Commission. Public sector debt is already 96 per cent of GDP, and rising. Rating agencies maintain a negative outlook on the country's creditworthiness as it seems increasingly unlikely that the government will be able to meet the budget deficit reduction targets set by the bureaucrats in Brussels.
In fact, France's proposed budget for 2015 fails to make any inroads into reducing the structural deficit below 3 per cent, having missed its original deadline of last year. The European Commission will decide in early March whether to initiate sanctions (read 'fines') against the government for failing to do enough to put its house in order.
Strong support: Italy's prime minister Matteo Renzi
Arrivederci Italia
If that sounds bad then it's nothing compared with the plight facing Italy, the third largest debtor in the world and one with a €2.1tn debt mountain. Following 11 quarters of contraction in the past three years, the country's GDP has declined by an aggregate 5 per cent since the start of 2012 and real output is back to levels last seen before the single currency was formed 15 years ago. Unable to balance its budget, gross public debt has ballooned to the highest in the eurozone at around 133 per cent of GDP.
Youth unemployment is over 42 per cent and even the European Commission acknowledges that unreported unemployment is the highest in the eurozone. The country's 12.3 per cent unemployment rate woefully understates the true level of joblessness. Add to that a budget deficit equivalent to 2.75 per cent of GDP, and the country's debt to GDP ratio is set to continue to rise given the impossible task facing the government of balancing its books with high unemployment eroding the tax take and suppressing demand.
At least the leader of the centre-left Partito Democratico party, Matteo Renzi, the youngest prime minister in the country's history, has strong popular support: his party won more than 40 per cent of the vote in the European elections. However, the government's pro-growth expansionary budget outlined for 2015 is unlikely to go down well in Brussels as it includes proposals to widen the country's fiscal deficit by the equivalent of 2.3 per cent of GDP, split equally between tax cuts and additional public expenditure. The tax cuts could potentially boost economic growth by around 0.2 per cent, according to analysts at Deutsche Bank, but this means Mr Renzi is on a head-on collision course with Brussels for failing to reduce the deficit. Although the European Commission has no power to formally reject Italy's budget proposals, it can request that they be reworked and resubmitted.
Deflation looms
To compound matters, persistently low and falling inflation across the region - core inflation in the eurozone has fallen to just 0.7 per cent once you strip out food and energy costs - means the menacing threat of deflation lurks in the background. And of course the ailing European economy has been further undermined by EU sanctions against Russia - estimated to have wiped 0.3 per cent off GDP this year, and a further 0.4 per cent in 2015.
So with Italy and France - countries that account for 35 per cent of the eurozone's total GDP of €10.2tn - failing to balance their books, let alone generate economic growth, it's hardly surprising that investors have been focusing more on the growth engines elsewhere in the world economy and given European equities a wide berth: the Euro Stoxx 50 index is up 1.3 per cent in 2014, trailing well behind the 9.6 per cent gain, again in the year to date, in the benchmark S&P 500 in the US. Factor in the 9.6 per cent depreciation of the euro against the US dollar in the same period, and the euro's 4.9 per cent decline against sterling, and this means unhedged foreign investors will be nursing losses on their euro-denominated European equity holdings.
Deeply unpopular: France's president François Hollande
However, despite all this gloom, this beleaguered continent has a chance of emerging from its economic straitjacket. Of course, it will need a helping hand to generate growth, the most likely being a bond buying blitz by the ECB on the corporate and sovereign bond markets and one that could come as early as the first quarter of next year, according to economists. This would not only have the effect of incentivising companies to invest, but funding these bond purchases through unsterilised quantitative easing (QE) would undermine the value of the euro and lead to favourable export conditions, too. I have outlined the likely impact of QE on currency and bond markets in an indepth article (Fireworks to set markets on fire).
There are risks though, the most immediate of which is the political situation in Greece and potential for the country to throw a spanner in the works if the radical left and anti-europe Syriza alliance, led by Alexis Tsipras, gains control of power. That threat is immediate as Premier Antonis Samaras would be forced into calling a snap general election if he fails to find enough opposition MPs to support his candidate for the Greek presidency this month. The risk is that Syriza – which is the most popular party with 31 per cent support in the latest opinion polls – would overthrow the EU-IMF regime that has funded Greece’s €245bn financial bail-out and lead to another bout of financial risk aversion in the eurozone.
That said, with the caveat in place that the ECB embarks on unsterilised QE, and Greece does not implode, then with a fair tailwind behind it, eurozone equities could post positive growth next year as hard as that may seem right now. Indeed, there are a number of reasons to believe this scenario could yet pan out.
Equities priced for recovery
Firstly, the 45 per cent slump in the oil price in the past six months is tantamount to a tax cut for consumers and will give a boost to companies through lower input and logistics costs. For example, the International Monetary Fund (IMF) estimates that the $40 a barrel fall in the oil price since mid-June could boost GDP by 1 per cent globally. This is positive for both internal demand in the eurozone and export trade.
Secondly, the depreciation of the euro against the US dollar is forecast to boost Germany's GDP by at least 0.5 per cent over the next 12 months, according to analysts at Commerzbank, reflecting the improved competitiveness for the export dominant country. As a rule of thumb, every 10 per cent fall in the euro against the greenback boosts the EPS of European companies by 10 per cent too.
Thirdly, it's worth considering the results from the third-quarter corporate reporting season. These showed that aggregate earnings of European companies increased by 12 per cent year on year even though revenues only rose by a minuscule 0.3 per cent. This follows earnings growth of 4.3 per cent in the second quarter for the Euro Stoxx 600 index. Primarily, this highlights the benefits of previous cost cutting that has taken place as companies realigned their cost bases to the more difficult economic conditions following the eurozone debt crisis.
As a result of this rationalisation, earnings of European companies now have greater operational leverage, which means that any positive news on the economic front will have a far bigger positive impact on companies' bottom lines given their slimmer fixed cost bases. In this scenario, the major beneficiaries are likely to be large industrials, machinery and healthcare companies with a heavy export bias and specifically with exposure to North America. The International Monetary Fund forecasts US economic growth north of 3 per cent for 2015, a figure that Canada almost achieved in its third quarter this year.
The fourth reason for cautious optimism on European equities comes down to valuation. At a microeconomic level, companies in Europe outside the financial sector have strong balance sheets and cash flow, leading to the likelihood of further dividend growth, cash returns and merger and acquisition activity. In the second quarter of 2014, European companies (excluding UK-based ones) grew their dividends by 18 per cent year on year.
Risk to the upside
Valuations are not stretched either: the MSCI Europe index is trading at around 13.8 times consensus earnings. Also, the equity risk premium embedded in the valuations of European equities is above its long-term average, according to analysts at Charles Stanley Stockbrokers. This undoubtedly reflects higher-than-normal recessionary risk, but it also means that the "surprise that moves the markets is likely to be from a positive, rather than negative, newsflow".
Furthermore, with European corporate earnings languishing around a quarter below their pre-crisis peak, there is potential for earnings to play catch-up, albeit in the near term this is most likely to be driven by export-led growth on the back of further euro depreciation. Indeed, it seems inconceivable that the euro will not depreciate further against the greenback given the disparity between the two economies and monetary policy being pursued by the respective central banks. In addition, if the ECB pushes the button on unsterilised QE, as markets are betting it will do early next year, then this will not only accentuate the currency weakness, but is positive for small and medium-sized enterprises too. I discuss the reasons why in my article on QE (Fireworks to set markets on fire).
The bottom line is that if there is any semblance of improvement in economic growth trends, which will have an immediate impact on corporate Europe, and if equity risk premia ease back from elevated levels as investors become more comfortable, then European equities have potential to surprise to the upside. It goes without saying that the structural reforms needed in the eurozone are another thing altogether, but we will let the politicians and bureaucrats in Brussels fight that one out.
