Should Investors Underweight Euro Area Equities Given Trade Wars, Elections, and the Weak Growth Outlook?

No. All three factors have weighed on euro area equity and currency markets to some extent in recent months. That has ranged from directly, by crimping economic activity; potentially dragging down future growth, by weighing on domestic economic confidence; or simply by denting the sentiment of fearful investors towards the region. However, a material degree of negativity is now baked into euro area asset prices, potentially tilting the balance of risks towards upside surprises. Nonetheless, catalysts for sustained improvement in euro area corporate fundamentals versus their peers are hard to find, so we recommend continuing to hold euro area equities at benchmark weights.

The threat of trade wars has weighed on sentiment towards the euro area since before the US election, when the odds of a Trump victory were rising. At that stage, a 10% universal tariff was pushed as the policy of the incoming administration. European assets were understandably underperforming in the face of that proposition, given the United States is Europe’s largest trading partner. Post election, a softer position was touted, with the idea of a universal tariff seemingly sidelined, allowing euro area assets to outperform in January. However, we have since witnessed President Trump ordering a 25% tariff on Mexican and most Canadian goods (now delayed until March), an incremental 10% tariff on Chinese goods, and stating his intention to impose tariffs on the EU. With Europe having retraced approximately half of the election-period underperformance, the balance of risks surrounding trade war developments may therefore be more evenly distributed again. What seems clear is that this facet of the European macro story is likely to keep volatility elevated, with performance subject to significant headline risk.

The upcoming German elections have added to the broader air of instability within the euro area. The collapse of the ‘traffic light’ coalition of the Social Democratic Party (SPD), Free Democratic Party (FDP), and Greens over fiscal disagreements has paved the way for the Christian Democratic Union (CDU) to likely lead the new government after the February 23rd election. They may be positioned to form a two-party coalition with the Greens or the SPD, potentially reducing governance instability via a clearer policy stance. In any case, the exclusion of the fiscally conservative FDP could allow for some modest fiscal easing. Germany’s ‘debt brake’ strictly limits budget deficits, but the new government might consider attempting to adjust this rule. Current polling suggests the CDU, SPD, and Greens may be just about able secure the two-thirds majority needed for such changes, though any immediate fiscal boost would likely be small, focusing on capital investment. Without legislative changes, technical adjustments might offer limited incremental easing. Meanwhile, though a degree of instability will likely remain a feature of French politics at least until fresh elections can be held, the fiscal drag this year may be less severe than previously forecast, with Prime Minister François Bayrou targeting a 5.4% deficit compared to the 5% goal under former Prime Minister Michel Barnier.

Low growth may be the most pernicious challenge facing the euro area currently. Growth in all three of its largest economies was flat to negative in the fourth quarter, with weak momentum potentially threatening the consensus 1% growth expected this year. Structural growth remains challenged by demographics and political fragmentation. Additionally, certain economies—notably Germany—are now also confronted by increased competition from China in particular industries. Indeed, trade wars are not solely the preserve of the United States—the EU imposed tariffs on several categories of Chinese exports on unfair subsidy grounds, and China has responded with measures of its own.

But even amidst this biting negativity, there are some green shoots. For one, the European Central Bank is likely to continue to cut rates materially this year. It can reduce rates by another 50 basis points before it reaches even the top end of its estimate of the neutral rate, while its confidence in further disinflation opens the opportunity to cut below neutral to support weak growth. Indeed, the cuts already delivered appear to be having an impact, with lending growth recently picking up materially, while the composite PMI has just inched back into expansionary territory. An important final piece of the jigsaw is that euro area household savings remain elevated. This precautionary behaviour is likely linked to shocks from some or all of the pandemic and associated inflation, the war in Ukraine, and political instability. If the current period of positive real wage growth persists, the repair of real wealth stocks may be a catalyst to reduce savings and increase consumption, aided by lower rates. If any of these current or potential tailwinds come through in a material way, future revisions to growth and earnings per share are more likely to be up than down.

Make no mistake that the euro area currently faces substantial headwinds from several sources and perspectives. However, this negativity is reasonably well priced-in to euro area equities in particular, such that there is a reasonable case to be made that upside surprises are more likely from here. Nonetheless, the corporate fundamentals of the euro area market look weak when compared to their global peers, despite some localised improvements in recent months. As a result, we believe for now that any such surprises would result in temporary, rather than sustained, outperformance. We, therefore, recommend continuing to hold euro area equities in line with benchmarks, while also remaining cognisant of the likely significant forthcoming headline risk surrounding tariffs.

Thomas O’Mahony, Senior Investor Director, Capital Markets Research