- The U.S. stock market has shifted from an aggressive bull market to one that slowly grinds higher.
- European companies are finally showing meaningful improvements in corporate earnings, although the strengthening Euro could put pressure on some entities.
- The ECB, like the Fed, looks to be finally ready to move away from the highly accommodative monetary policies of the last nine years.
- If Europe can achieve fiscal policy coordination it could result in a move from what has been a momentum/currency-driven rally in Europe to one that favors sector selection and stock picking.
“Market Watchers” Have Been Reduced to “Inflation Watchers”
Since the end of the U.S. corporate earnings season there has been a dearth of significant domestic economic news. In fact, with half of the dual mandate of the FOMC fulfilled (employment), “market watchers” have been reduced to “inflation watchers,” trying to deduce whether the small rise in prices is enough to move the Fed to its fourth rate increase since the tightening cycle started in 2016. The late summer market volatility was simply a function of the endless news cycle around U.S. politics and the recalcitrant leader of North Korea. This sparked a shift from an aggressive bull market rally to one that slowly grinds higher. We have also seen many overseas markets catch up to the U.S. after years of underperformance, with even continental Europe participating. These gains have been fueled in part by a European economic recovery which has also boosted the Euro.
Over the last two quarters, U.S. corporate earnings have staged a resurgence, as have European earnings. Companies across Germany, France, Spain and the United Kingdom have registered back-to-back quarters of earnings growth. However this may be nearing an end. Spain and France are the only European countries to show more earnings upgrades than downgrades going forward. In contrast, Germany has seen a large negative change in consensus revisions over the past month, due in part to a squeeze in profit margins from the strength in the Euro.
The Euro area economy seems to be on solid footing and the European Central Bank (ECB) has taken notice. The most recent ECB meeting was largely a non-event but policymakers were in broad agreement that the need for quantitative easing was coming to an end. As a consequence, this fall they are expected to announce reduced bond purchases for 2018. One possible path forward discussed by the ECB included – but is not limited to – cutting asset purchases by 50 percent.
Interestingly, the strength of the Euro was not a source of major concern at the September ECB meeting. This was primarily a function of Fed interest rate hikes getting priced farther out on the calendar while the ECB is closer to removing accommodation. In the near term, we believe the EUR/USD exchange rate will be driven by geopolitics and the Fed’s plan to raise rates, rather than the actions the ECB takes to withdraw liquidity. One new twist is that European officials are beginning to recognize that the stronger Euro may present a challenge to the economic and earnings recovery for the region.
An obstacle that the euro area has largely avoided is the political battles that have hampered the U.S. economy. That is not to say they don’t exist but, with the exception of Brexit and perhaps immigration policy, none of the political disagreements affect the region as a whole. With the German elections slated for the end of this month, it is an almost universally held view that Angela Merkel will win a semi-historic fourth term as Chancellor. A popular, but not consensus, opinion is that she will team with French President Macron to implement transformative policies that stimulate the region’s economy and deepen European integration, which could have material implications for capital inflows and European asset prices.
Ultimately, the engine driving continental Europe may be on the verge of switching gears from monetary policy stimulus to fiscal policy coordination. This could provide support to moderate growth but stoke a bit of inflation and temper the movement in the Euro. Corporate earnings should expand but at a slower pace than the robust double-digit gains registered in the Euro Stoxx 50 index the last two quarters. This could result in a move from what has been a momentum/currency-driven rally in Europe to one that favors sector selection and stock picking.