Grappling with a number of significant headwinds

Unlike the rest of the world, the European economy has been hit by not one, but two major crises in the last decade. A few years on, we consider whether Europe is set on a path to recovery.

In 2008, the collapse of the US mortgage market sent shock waves across the globe and triggered international financial turmoil. The global financial system, including financial markets in Europe, came under severe strain. Disruptions in the flow of capital led to what became known as the ‘credit crunch’, resulting in the greatest global economic recession since World War Two.

Global credit crunch 
Then in 2010, the European economy was hit by another set of misfortunes. Fiscal deficits and accelerating levels of debt exacerbated financial distress in some European countries, particularly those on the continental periphery. In the wake of the global credit crunch, a number of European governments faced soaring borrowing costs and lower tax revenues, which meant that many required emergency financial assistance to meet payments and avoid bankruptcy. This was known as the ‘European sovereign debt crisis’.

This series of challenging financial events from 2008 to 2011 led to an environment of rising unemployment, tight credit conditions and fiscal drags in Europe. Worries over the survival of the monetary union dominated headlines, particularly in the first part of 2012.

European financial markets 
On 26 July 2012, Mario Draghi, president of the European Central Bank (ECB), made a speech that marked a turning point in the recent path of European financial markets. While most market participants believed Europe to be at the brink of collapse, Draghi stated that the ECB was ready to ‘do whatever it takes’ to save the monetary union and preserve the euro currency.

These words resonated strongly across the investment community. Many interpreted Draghi’s comments as a guarantee to the ‘euro-project’ and believed that the likelihood of a member-state defection was reduced.

Eurozone breakup risk
As an immediate aftermath, Spanish and Italian government bond spreads (relative to German government bonds, known as ‘bunds’) tightened significantly to pre-crisis levels, signalling a reduction in the perceived risk of a eurozone breakup. Periphery equity markets also reacted positively, boosted by an increased level of economic confidence, benefiting investors with exposure to these markets.

These positive developments occurred at a time when structural reforms in peripheral countries were starting to take shape. In response to the debt crisis, significant measures were introduced by a number of European countries (in particular Ireland, Portugal and Spain) to repair public finances. This was undertaken in tandem with European Union–wide policies, including fiscal consolidation, monetary easing and the promotion of structural reforms, all of which aimed to restore confidence in the economy, shore up business and labour markets, and bring back competitiveness.

Stimulus to the economy 
Europe has had to grapple with a number of significant headwinds in the last few years: fiscal austerity, deleveraging of the private sector and an undercapitalised banking system, to name a few. The ECB’s accommodative monetary policy since 2012 – including the latest large-scale quantitative easing programme which began in March this year – has provided a significant amount of liquidity to the markets, helped reduce borrowing costs and acted as a stimulus to the economy.

While channelling quantitative easing money into the real economy has yet to reach its full extent, we believe these policies represent a step in the right direction. There are a number of positive factors emerging that shouldn’t be underestimated. A continuing reduction in the cost of bank loans for small and medium enterprises, and further increase in demand for credit in the eurozone (as well as the gradual recovery in business activity from the weakness of previous years) are all worth considering. These positive dynamics indicate that the euro-area’s economic momentum can gradually improve.

Banking system weaknesses
Another notable development has occurred on the banking side. European regulators have been proactive in addressing weaknesses in the banking system, primarily focusing on reducing leverage and increasing capital. Following the asset quality review and stress-testing exercises conducted by the ECB, of which the final results were published in October 2014, European lenders are in a much better capital position compared to previous years. This should allow them to resume their role as financial intermediaries and channel investments into the real economy.

Already there are signs of improvement on that front: credit growth in the private sector has turned outright positive in the first quarter of 2015, for the first time since 2008. Ultimately, more structural reforms remain crucial for a sustainable recovery in Europe, and some have questioned their slow pace of implementation to date. However, following the progress achieved in countries such as Spain, Portugal and Ireland, we are now seeing firm action by Italy and the start of reform activity in France.

Real disposable income 
Since the beginning of 2015, low oil prices, low borrowing costs and a weaker euro have provided a tailwind for households’ real disposable income and corporate profitability. Confidence is gradually returning to European consumers and businesses, both in core and periphery countries.

The combination of all these factors should continue to boost domestic demand and further improve the playing field for corporates. Consequently, it seems logical to expect growth forecasts for corporate earnings to pick up from depressed levels and move higher as the year progresses.

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THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.
PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.