Once again, European Central Bank (ECB) president Mario Draghi has set pulses racing with his recent comments that the body is poised to loosen policy.
His comments followed the May ECB meeting and showed it is concerned at the continued disinflation within the eurozone and the impact of a strong euro on the region’s competitiveness.
With the ECB updating its inflation forecasts for the June meeting, and no immediate uptick likely, expectations for another interest rate cut, which would take the deposit rate into negative territory, are expected.
Furthermore, Mr Draghi’s hints at some form of quantitative easing (QE) have increased expectations of further easing by unconventional means before the end of the year.
The economic data from Europe this year has been encouraging, and the eurozone as a whole is expected to grow at a pace of more than 1 per cent this year.
While not exactly stellar growth, it is a positive step, given the imbalances in performance across countries. Some countries, notably Spain, have taken significant pain, made reforms and are well on the path to competitiveness.
Meanwhile France has seen very little in the way of change - possibly as a result of a lack of market pressure.
We have also seen progress, albeit not at the pace seen during crisis phases, towards banking and fiscal union.
The Asset Quality Review [AQR] will conclude in the autumn and this should loosen bank lending over time This will be a vital step given the limited access to credit for European companies, particularly small and medium firms which have the potential to be real drivers of economic growth and employment. Until the AQR is concluded, however, continued bank deleveraging will act as an impediment to growth.
So there is some good news about, but how much of this is already reflected in share prices?
We would argue a muted economic recovery is already priced in but accept a boost could come for risk assets from any QE-type policy, as we have seen previously in the USA and Japan.
European equities are no longer cheap and while there is significant potential upside in European earnings, which remain 35 per cent below their 2008 peak, we do not think European growth of approximately 1 per cent will be particularly supportive.
While just more than 50 per cent of European earnings come from outside the eurozone, global growth is unlikely to be strong enough to provide a significant boost to European earnings.
The next phase of structural reforms and slowly rebuilding demand to reduce unemployment, increase growth and reduce debt will be far more difficult.
We believe this will leave Europe behind the USA and even the UK in terms of healing the wounds from the financial crisis. There are glimmers of hope and certainly QE would provide a boost to European risk assets but this may prove to widen the disconnect between European equity prices and fundamentals, rather than boost real economic demand and drive the reforms needed to restore the eurozone to sustainable economic growth.
