Euro zone recovery comes from the outside-in

The euro zone should continue to recover as it emerges from the recessions and crises of recent years, writes Cesar Perez of JP Morgan.

We have called 2014 the year of “show me the money”.

We expect the turnaround in growth that has developed in the United States and Europe over the past two years to show through in equities earnings growth. The support central banks are providing for markets in the developed economies, together with better economic fundamentals in the US, Europe and Japan, are the main factors contributing to sovereign yields tightening across the board in the non-emerging markets universe.

The euro zone should continue to recover as it emerges from the recessions and crises of recent years. We believe the region will register about 1.2 per cent growth this year (1.4 per cent in the core and 0.8 per cent in the periphery). There has been better economic data coming through consistently in these past two years – the purchasing managers’ indexes (PMIs) have improved not only in the core but also in the periphery.

Periphery countries expanded steadily in exports because of rapid improvements in relative cost competitiveness as high unemployment put downwards pressure on wage growth. The result was the first leg of the recovery, which has consisted of the elimination of the periphery’s current account deficit largely because of a collapse in domestic demand and imports as shown in better manufacturing indicators. As the relative export performance should continue to improve, we now expect the domestic consumer to start contributing to the growth picture, as indicators such as retail sales have started picking up from cycle lows.

We believe this is a very positive development. At the beginning of the year, we waited for the improvement in hard data such as retail sales to manifest. Given higher operating leverage in Europe, even a small increase in domestic growth can translate into improving operating margins and earnings next year.

We believe that the better hard data that has started to come in provides validation for European earnings. Our models for forecasting earnings growth leads us to expect a higher single-digit growth rate for European equities thisyear.

Spain and Italy are showing a better economic temperature and their political environments also show support of their recovery. So far we have seen indicators such as current account deficit and exports improve. We expect their economies to show validation of this growth by benefiting domestically oriented companies. With the periphery consumer slowly waking up, the next leg of the recovery will focus on the domestic recovery.

We expect European small and mid-capital companies, especially in Spain and Italy, to continue to outperform large-capital ones in a recovery scenario, as they are geared to the domestic side of their economies. The economic environment is supportive for mid-size companies – our analysis shows that they outperform when PMIs are accelerating. This is the case now.

Furthermore, our models show that small and mid-size companies do best in an environment such as now, when the euro strengthens, volatility stays low, the economy improves (European retail sales are also trending upwards) and rates do not yet rise. Since improvements in consumer sentiment and fundamental data are on the cards in the near future and rising rates are not yet a risk in Europe, we believe Italian and Spanish small and mid-size companies are positioned favourably to benefit from the gradual recovery in the region.

Cesar Perez is the chief investment strategist for Europe Middle East and Africa at JP Morgan Private Bank

Follow us on Twitter @Ind_Insights

Published: May 21, 2014 04:00 AM

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