What is the outlook for Europe in 2020?

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What is the outlook for Europe in 2020?

European equities were surprisingly buoyant in 2019 with the MSCI Europe ex UK index seeing gains of 20% in sterling terms, while the Stoxx 600 recently hit a record high and is up 20.5% over the year, despite political uncertainty and a slowdown in economic growth.

Indeed, although the European economy is now in its seventh consecutive year of growth and is forecast to continue expanding in 2020 and 2021, according to the European Commission's autumn forecast, the forecast is at a slower rate than predicted earlier this year.

Euro area gross domestic product (GDP) is now expected to expand by 1.1% in 2019 and by 1.2% in 2020 and 2021, revised down from the Summer 2019 Economic Forecast, which predicted growth of 1.2% and 1.4% respectively.

Across the EU, GDP is forecast to rise by 1.4% in 2019, 2020 and 2021, with the 2020 forecast revised down from summer figure of 1.6%.

However, in a boon to markets, the European Central Bank (ECB) cut its deposit rate to a record low of -0.5% from -0.4% in September and reintroduced quantitative easing in November.

With Christine Lagarde now at the helm, all eyes will be on the ECB President to see in which direction she takes monetary policy. Andrew Kenningham, chief Europe economist at Capital Economics, said in a recent note he expects further policy stimulus down the line.

"The Bank's strategy review will probably take at least a year and, in the meantime, any policy decisions will have to aim for inflation of 'below, but close to, 2%'. By Christine Lagarde's own admission, the ECB's inflation forecasts fall short of this target, even for 2022.

"Accordingly, we have pencilled in a reduction in the deposit rate from -0.5% to -0.8% by the end of next year, and an additional €10bn per month of corporate bond purchases from mid-2020," Kenningham said.

In terms of economic growth in the eurozone, Kenningham said it is likely to be sluggish until mid-2020 and recover more slowly than the ECB has factored in.

"The most reliable business surveys have stopped falling in the past few months, but still suggest that growth has more-or-less stalled. More fundamentally, the main components of demand are likely to be weak next year.

"Household consumption growth is slowing because employment is softening, and wage growth is also coming off the boil. Business investment also looks set to slow sharply. And fiscal policy will be only mildly expansionary."

Marion Amiot, senior European economist at S&P Global Ratings, agrees that growth is likely to be muted in 2020, forecasting GDP will rise by 1.0% in 2020 and 1.2% in 2021.

"While recent data suggests the industrial slump might be bottoming out, we do not expect a sharp rebound in industrial activity," Amiot said.

"If and when the data flow fails to show more signs of improvement to growth, we think the ECB will have to cut its deposit rate by another 10 basis points, perhaps in March 2020.

"That said, given a backdrop of unprecedented easing since the last crisis, monetary policy is slowly running out of firepower. Any fiscal stimulus would therefore be a welcome upside risk to our 2020 scenario.

"It simply would be more effective for reflating the economy than lowering interest rates further. For now, we stick to the view that the ECB is unlikely to end quantitative easing before 2021 or raise rates before 2022," she added.

David Riley, chief investment strategist at BlueBay Asset Management, said monetary policy in Europe is "near the point of exhaustion".

"The ECB has embarked on a strategic review of its monetary policy and stated it will 'continuously monitor the side effects' of its policies - an acknowledgement by new ECB President Christine Lagarde of the deteriorating cost-benefit calculus of negative policy rates and QE2."

However, with investors holding investment-grade corporate credit as a 'safe' alternative to negative-yielding European sovereign bonds, and the ECB committed to buying €20bn of bonds monthly - including €4-6bn of investment-grade corporate bonds - until inflation reaches its near 2% target, Riley has identified opportunities in the subordinated debt of investment grade-rated companies and banks.

"In our opinion, investor, as well as ECB, demand for investment grade credit could see a further grind tighter and compression in spreads between higher and lower-rated debt, even if eurozone economic data remains tepid.

"There is approximately $12trn of negative-yielding debt, mostly European and Japanese government bonds, accounting for almost one quarter of global fixed income assets.

"Only some 10% of debt issued in the major domestic and Eurobond markets yields 3% or more - mostly sub-investment grade-rated developed market credit and emerging market debt.

"Against this backdrop, the subordinated debt of investment grade-rated companies and banks offers attractive risk-adjusted yields. European bank debt, especially contingent convertible bonds, offers mid-single-digit yields and a meaningful spread pick-up over similarly rated non-financial corporate debt.

"Rating agency and regulatory changes could also be supportive of the asset class in 2020 and it remains a core holding across BlueBay multi-asset and credit strategies."

Equities

Looking again at the equity markets, it is clear the managers who are positive on the region are remaining selective, while the growth versus value debate rages on.

Jeremy Podger, manager of the Fidelity Global Special Situations fund, has identified value opportunities in Europe: "In European equities, selectivity remains key. We continue to avoid expensive defensives but are finding interesting value situations and unique businesses within the region that are hard to find elsewhere."

Head of European equities at Hermes Investment Management, James Rutherford, also said there is still the potential for a value rally despite growth stock valuations sitting at premiums not seen in the past decade.

"For many value stocks, year-on-year earnings growth should start to improve as we move into 2020. But in light of some mixed manufacturing - and even services - data, it may well take more than just easier year-on-year comparisons for there to be a meaningful and sustained shift from growth to value," he said.

"This would require a clear catalyst in the form of a settled US-China trade dispute, a co-ordinated increase in fiscal spending, a shift in the yield curve or agreement on the interminable Brexit question.

"None of these seem likely at present, but that could change quickly and given how bearish sentiment is any rotation could be significant.

"Our decisions are not driven by style characteristics, but we are aware of the valuation dichotomy. Whether we see a sustained style rotation or not, the portfolio is well balanced. Over the long term, bottom-up fundamentals should win."

However, Stefan Gries, co-manager of the BlackRock Greater Europe Investment trust, warned against buying value stocks.

"While fiscal policy and falling political uncertainty could both give a boost to the region, we would caution on buying specific exposures based on macro narratives alone, such as 'buy value'.

"Europe continues to have areas of the market that appear to be value traps, with whole sectors suffering from falling profitability. In many cases, management teams have limited ability to turn the tide.

"Selectivity in the region and a focus on long-term winners underpinned by superior fundamentals could be meaningful for the overall return achieved from the region.

"We continue to hold a preference for well-positioned luxury goods and aerospace companies and avoid cyclically and structurally challenged areas such as autos and banks."

Elisa Mazen, head of the global growth equity investment team at ClearBridge, prefers growth stocks. "We remain very optimistic about non-US growth equities, particularly in Europe," she said.

"People tend to talk negatively about Europe, but many of these growth equity companies continue to do very well. There has been a sell-off in growth versus value, but that should come back.

"Good opportunities exist for continued earnings growth and even multiple expansion. European growth equities, compared to counterparts anywhere else, are very inexpensive.

"Valuations in the United Kingdom and Europe are attractive, particularly compared with US equities. European stocks are at 50-year lows versus the US, which has represented a good entry point the last two times performance dispersions became this extreme."

However, with Brexit uncertainty still prevalent, not all managers are bullish on European equities at this point.

Fiera Capital's Candice Bangsund, vice president and portfolio manager, global asset allocation, said: "We remain underweight in European equities. Persistently stagnant growth across the eurozone and a vulnerable banking sector could hinder financial conditions and European equity performance, while uncertainty regarding the future of the United Kingdom continues to place undue pressure on UK stocks."