EQ Investors' head of research gives us her view on why small caps will benefit from the upside in the euro.
'While geo-political risks remain, evidence points towards a stronger European economy. An improvement in growth, coupled with reasonable valuations (relative to other regions), strong momentum and light positioning are hard to ignore. As such, we have recently increased our European equity exposure, in fact it is our most significant move this quarter.
Economic growth in the region is picking up speed, evidenced by flash GDP estimates confirming solid Q1 growth with Q4 numbers revised higher. Purchasing Managers’ Indexes (PMIs) have accelerated sharply, reaching cyclical highs. Though levels vary, aggregate eurozone unemployment rates are now at their lowest level since 2009. We also see a number of other positive tailwinds.
After a period of negative earnings growth, corporate earnings in Europe are now outstripping their US counterparts, and are only underachieving relative to the likes of Latin America and the UK, given the latter are significant beneficiaries of recent commodity and currency moves.
Monetary and credit conditions in the euro area continue to improve. Fiscal tightening in-line with the Maastricht Treaty requirements, which saw government budget deficits reducing, is now easing. Alongside this, the European Central Bank’s (ECB) monetary policy remains highly accommodative, and while headline inflation is rising, core inflation remains flat, meaning its hand is not being forced.
In addition, the latest ECB bank lending survey points towards signs of credit growth in Europe, or at least an end to the bank deleveraging cycle, which has been ongoing since 2008. Having been a huge headwind for GDP growth, this will likely provide a significant boost to investment which has been the weakest aspect of this cycle.
Investors substantially reduced their allocations to European equities over the last few years, as the European recovery lagged that of other developed markets, leaving positioning in the region light.
In our view, this now appears to be reversing, drawing money back into the region. We expect to see investors continue to add to the asset class if it continues to perform well, which would act as a further tailwind.
Political risks may still present some concerns, despite the French election passing as expected. Following president-elect Emmanuel Macron’s victory, we now look to the third and fourth rounds (the parliamentary battle), which will decide the composition of the National Assembly. Without its support, Macron’s power base would be much reduced.
The French political landscape has changed significantly, so any outcome is hard to predict. However, we do not expect it to bring the French membership of the European Union in doubt and so, while optimism may be dampened, we do not see the European growth story being derailed.
More specifically, we believe in the domestic growth story in Europe, driven by improving sentiment and the possibility of deleveraging coming to an end. If we also see upside in the euro, we believe that small caps would be the primary beneficiary.'
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