Europe has experienced improving macro fundamentals in the past quarters. While still an early cycle recovery, we note that consumer confidence and PMIs have picked up, especially in Italy and Spain. Furthermore, the credit impulse has also improved for both households and corporations. Interest rates charged by the banks for corporate loans are also converging towards lower levels (for example, a company in Spain used to have to pay 6 per cent or more on average to get a bank loan; that rate is now around 3.5 per cent).
For the recovery to take hold sustainably, the rest of the world also needs to grow. Therefore, we believe that the global Q1 drag is manageable so far for Europe, but any further disappointment would affect euro zone growth. The customary European risks persist, with Greece still not enrolled in a new bailout programme and regional elections taking place in the periphery throughout the summer. We do not believe any of these to have systemic risk potential for now, especially as the ECB has proved its full commitment to the region.
The ECB’s quantitative easing (QE) has had a beneficial momentum impact, firstly in the currency space, with the euro depreciating trend boosting the prospects for exporters. However, the fact that indicators such as retail sales and car registrations are picking up higher than at 2011 levels indicate that the European consumer is also recovering. While the ECB’s impact on the economy will take time to fully affect the cycle, the effects in the markets are already prominent, illustrated by the aggressive move in sovereign government bond yields in April / May.
The better economic news coming from Europe meant that growth expectations had increased accordingly. However, duration remained priced for much lower growth, with 30-year German bonds bottoming at 0.4 per cent yield in April.
Furthermore, the recovery of the oil price meant that there was a significant increase in inflation break-evens from January onwards, while European corporate yields remained stable.
We note that the reversal in euro zone debt markets mostly acted on the higher quality securities, at the longer end of sovereign curves. We see this duration repricing as having an equivalent in equity markets, as European quality stocks have also experienced overvaluation of quality from 2014 to the beginning of this year.
In a nutshell, the record low levels of sovereign bonds validated the climax for the stocks most sensitive to duration that took place three months before.
This is why we expect cyclical stocks to be favoured by the market in Europe going forward, reversing the previous year’s momentum of high-quality balance sheet stocks, with low sensitivity to credit conditions. We believe there is fundamental support for this development as well: credit growth is finally picking up and the economy is in the early stages of a cyclical upswing.
Cesar Perez is the global head of investment strategy at JP Morgan Private Bank.
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