Our bottom line: We actually left feeling more encouraged about the prospects for risk assets in the near term, though some of our long-term concerns about the “Union” remain intact. See below for full details on our latest views, but our initial Thoughts from the Road are as follows:
Despite significant political uncertainty — and almost in spite of itself — European GDP continues to chug along at a steady clip. In fact, we are lifting our 2017 GDP forecast to 1.7% from 1.4% previously, driven by better than expected investment trends. Maybe more important, though, is that our quantitative GDP model is forecasting robust growth in Europe of 2.5% for 2017 (Exhibit 11). This forecast is driven largely by the powerful effects of the European Central Bank’s highly accommodative monetary policy regime, partially offset by stagnant housing market concerns. However, if mortgage lending growth does accelerate, implied growth by our model could be even stronger, though we fully acknowledge an overall political risk discount of 50-75 basis points to our quantitative growth model likely makes sense in the current environment.

Investors should continue to think about a European macro environment where consumption, particularly around experiences, remains compelling relative to overall trend growth. This viewpoint is consistent with an emphasis on sectors such as travel, health/beauty, and home improvement. By comparison, we remain cautious on global trade, and our research shows increasing examples of China insourcing manufacturing equipment that used to be built by leading European industrial enterprises (Exhibit 10). Our bigger picture conclusion is that globalization flows and production increasingly now appear to be moving towards more of a regional model, with a particular emphasis on Asia, Europe, and the Americas.

Europe continues to barrel down the path of a two-tiered economy, which is likely long-term unsustainable, in our view. Specifically, there is a large and growing dichotomy between Germany, with its strong growth, and the rest of Europe, Italy in particular. See below for details, but Italian GDP is now seven percent below its 2008 level in real terms; by comparison, Germany is a full eight percent above its 2008 level in real terms. During the next few quarters we believe that the ECB will allow Germany to run “hot,” leading to a further widening between Europe’s largest and fourth largest economies. Somewhat ironically, the better Germany’s GDP performs, the more German bunds the ECB has to buy, while Italy’s economic underperformance currently leads to less ECB purchases of Italian sovereign debt. We view these types of divergences as unsustainable, underscoring our belief that Europe will need to implement monetary and fiscal policies that better smooth economic growth and equality across the region; otherwise, we fear it will lead to even more dire populist reactions, particularly if immigration issues are not reconciled

Eoin Treacy's view

These are common sense points from what we might consider to be a dispassionate observer of the evolving political and market situation in Europe. Europe is pushing through agreements like the Bank Resolution and Recovery Directive and the European Deposit Insurance Scheme. 

The former was applied to the bankruptcy of Banca Monte Dei Paschi di Siena but major concessions were made to unsecured bond holders and so far what we have evidence of is that rules are applied in one manner to small countries, Cyprus for example, and in quite another manner for larger countries; namely Italy and even France. 

The European Deposit Insurance Scheme is due to come into effect in the early 2020s and can only be implemented once the Bank Resolution and Recovery Directive has weeded out the weakest banks to ensure the Insurance scheme isn’t immediately overwhelmed. The problem however is that these institutions are being created too slowly to have a meaningful impact on the market today. The fact these measures are taking place at a bureaucratic pace rather than responding to the urgency of the rise of populism virtually ensures additional political tension later. 

Nevertheless it often does one well to remember that we buy companies not countries and that the ECB is not likely to raise rates pre-emptively. The Euro pulled back from the region of the trend mean and the $1.08 level last week and has been hovering close to $1.0650 this week. A sustained move above the trend mean will be required to question medium-term supply dominance.