Political challenge to Europe's growth

Jeffrey Sacks

by Jeffrey Sacks, Capital Markets Strategist - Europe, Middle East and Africa

February 8 2017

The Citi Private Bank Global Investment Committee is slightly underweight European equities, based on concerns that the fragile growth upturn could be increasingly challenged by rising political pressures. Our favoured markets are Germany and Italy. UK equities are neutral, supported by a high average dividend yield of over 4%, but with economic strength likely to be gradually sapped as the prolonged Brexit negotiations begin. We expect the markets to see higher volatility in the year ahead. Clients should remain selective.

The FTSE 100 is now 22% higher than levels seen after the post-Brexit vote sell-off. While 16% depreciation in Sterling over the same time frame has been driving the move, supporting the FTSE’s many foreign-currency earning firms, US dollar-denominated investors have endured a substantially worse performance than local investors.

Since a sustainable rebound is not expected in Sterling – see below – we anticipate a similar dispersion in performance looking forward. The more domestically orientated FTSE 250 has caught up with the positive FTSE 100 performance, but we remain cautious on its outlook, given that we foresee the domestic economy weakening over the course of the year.

The UK data so far has remained remarkably resilient, particularly the services sector, while the outlook for cyclical sectors has been supported by the weaker currency as well as the maturing global economic cycle. The concern with the UK economy is that the devil of the Brexit negotiations will be in the sectoral details. We should be prepared for disappointments in the months ahead. At this stage, it is too early to make detailed sectoral adjustments to forecasts. In aggregate, however, it seems unlikely that there will be further upside surprises in the data.

In Europe, equities have rallied nearly 6% over the last three months, led by the financial sector, which has seen a strong recovery as yield curves have steepened, and as capitalization and litigation concerns have lessened. Energy companies should remain supported by the continuing grind higher in oil prices, which we expect to hit US$60/barrel by the end of 2017. Selective opportunities in healthcare should emerge this year following the de-rating in the sector last year. Finally, the technology sector should see above-average earnings and sales growth. In the current earnings season, 22% of companies in the Stoxx Europe 600 have reported annual earnings. The standouts so far have been exporters, which are generally seeing improved earnings due to a weaker Euro and British pound.

As well as being more selective over the year ahead, investors will need to have conservative return expectations, and take advantage of the higher volatility that is likely.

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