Is another global recession right around the corner? That growing fear among investors is manifest in European assets, for which global tensions have put a spotlight on European banks. But despite the faint echoes of the 2011–’12 crisis in Europe, this is no rerun of history. The reality is, at the same time, more mundane and more complex. Recession risks may have risen, but we still envision a year of tepid yet positive global growth.
For an asset allocator, Europe might well be thought of as a perfect test tube for the experimental — and potentially volatile — mix of economic recovery, inventive monetary policy and untested financial regulation. From an investor’s perspective, Europe offers tantalizing dividend yield and pro-cyclical policy stimulus tempered by the scars of the more recent euro zone banking and sovereign crisis.
How should investors think about Europe now? In our view at J.P. Morgan Asset Management, the trinity of global growth, the local banking sector and central bank policy will be especially important for European assets in 2016.
The outlook for European growth is on reasonably solid footing. Nevertheless, Europe is a mature and relatively low-growth region. The domestic picture continues to improve, with an uptick in consumer credit demand and improving confidence acting as an anchor for growth. Yet Europe is more internationally exposed than the U.S. — rendering the emerging-markets slowdown and the subsequent slump in world trade as significant drags. The net result is slow but steady domestic growth, mediated by a lingering concern that Europe could import economic malaise from emerging markets and snuff out the nascent recovery.
As for equities, the poor performance of Italian stocks so far this year highlights the second key consideration for European assets: the banking sector. Banks account for 25.6 percent of the market weight of the Italian FTSE MIB index, compared with 13.8 percent of the Euro Stoxx 50, 8.8 percent of the French CAC 40 and just 1 percent of the German DAX. Renewed concerns about Italian nonperforming loans have snowballed into broader concerns about banking sector liquidity, solvency and earnings.
The liquidity and solvency of the European banking sector are no longer systemic issues, in our view. Liquidity metrics are at barely a tenth of the level they hit during the 2008–’09 financial crisis and a sixth of the peak from the euro zone crisis. Lower reliance on wholesale funding plus European Central Bank liquidity backstops are limiting the risk of a liquidity crisis. Solvency fears are also exaggerated. Common equity tier-1 ratios — a key metric for bank solvency — are a creditable 12.8 percent, versus a precrisis low of about 7 percent, and loan-to-deposit ratios are close to 100 percent, down from 112 percent before the crisis.
Investors and regulators are beginning to question whether the pro-cyclical capital buffers now in play in Europe could be a problem in times of crisis. Untested elements of the capital structure — notably contingent convertible bonds (CoCos) — have caused concern. At the margin, there is a risk that these could act as an accelerant, rather than a dampener, of stress for a bank in crisis. At current bank capital ratios, we do not believe that this is an issue.
What is a pressing concern for the banking sector in Europe is earnings. A combination of low interest rates, post–financial crisis workouts and pending regulation all weigh on earnings prospects for financial firms.
The final element of the mix is central bank policy. We expect that the ECB will take deposit rates further negative by 10 basis points in March. The market reaction to the recent Bank of Japan negative rate policy will likely discourage policymakers from relying solely on negative rates for monetary stimulus, however. We are reassured that the ECB can bring other tools to bear: Extending and expanding quantitative easing, widening the pool of eligible securities and tweaking the collateral rules would, in combination, send a powerful policy message. In our view, the ECB will look to provide stimulus across a range of policy tools, as it fully understands the need not to undermine the earnings outlook for a still-fragile European banking sector.
What does all of this mean? The level of growth probably won’t be enough to persuade investors to ignore the greater uncertainties and tighter financial conditions that market participants now face, so we have a low appetite for risk. At the same time, risky assets aren’t cheap enough to overcome investor caution. The result in the near term is likely to be a nervous trading range with poor volumes and an obsessive focus on policy.
At the margin, we’ve grown less optimistic about European assets. The notion that the recovery is over and the ECB is out of options is wide of the mark, however. We maintain a modest preference for European equities, particularly relative to Japanese stocks — not least for the fact that the dividend yield is compelling, and as a proxy for global growth, European equities offer a stronger fundamental case than other global growth proxies.
On the credit side, we anticipate that a step-up in ECB asset purchases will lead to spread tightening. As a result, we believe, European credit can continue to serve as an attractive portfolio diversifier.
We interpret the volatility in European assets as an aftershock from the last crisis, rather than the start of a new one. Yet until global growth concerns truly resolve, Europe’s economic future will be heavily reliant on the domestic recovery — and that, in turn, depends greatly on the strength of the banking sector.
John Bilton is head of global multiasset strategy at J.P. Morgan Asset Management in London.
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