By Bill Witherell, Ph.D.
Eurozone equity markets have declined in step with global markets in a widely expected market correction. While there has been some recovery in the first two days of this week, it is not yet clear that the correction has run its course. Concerns that interest rates in both the United States and Europe will rise faster than had earlier been expected appear to have been a trigger, with technical factors amplifying market swings. Following a correction in early 2016, equity markets climbed steadily until they fell off the cliff at the end of January. The market gains in 2017 were exceptional. The US equity market gained 21.8% as measured by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY); and equity markets outside of the US gained even more, 27.8%, as measured by the iShares MSCI ACWI ex-U.S. ETF (NASDAQ:ACWX). A correction was long overdue.
Eurozone equities peaked on January 26th, in sync with the U.S. and other major markets. In most cases, however, the subsequent declines in the eurozone were more moderate. While SPY was down 2.02% year to date at the end of last week, the iShares MSCI Eurozone ETF (BATS:EZU) lost 1.24%. Several eurozone markets performed considerably better. The iShares MSCI Spain Capped ETF (NYSEARCA:EWP) declined only 0.31%; the iShares MSCI Belgium Capped ETF (NYSEARCA:EWK) still had a positive year-to-date return of 1.90%; and the iShares MSCI Italy Capped ETF (NYSEARCA:EWI) registered a 4.14% year-to-date gain. German equities, in contrast, underperformed. The iShares MSCI Germany ETF (NYSEARCA:EWG) was down 2.85%. On Monday, eurozone equities followed the recovery in the US and Asia, but then fell back a bit on Tuesday. Market volatility remains high.
Fundamental factors suggest the lengthy bull market in eurozone equities still has legs. The future prospect of higher interest rates represents the greatest risk to this outlook. The European Union has raised its growth forecast for the eurozone economy in 2018 to 2.3%. Recent strong data for both industrial production and retail sales support this forecast. One of the best leading indicators, the HIS Markit Eurozone Composite Purchasing Managers' Index (PMI), stood at 58.8 for January, the highest reading for this indicator since June 2006. Economic output growth was strong in all the major eurozone economies, with France registering the strongest growth and Germany, Italy, and Ireland close behind. Business confidence is reported at an 11-month high.
The strong growth is beginning to put some pressure on prices. Input and output costs are both rising. The strong euro is likely to have a moderating effect on import prices. Nevertheless, if inflation does gather pace significantly, particularly in the second half of the year, monetary policy would then very likely become more hawkish, with the European Central Bank advancing its schedule for reducing its bond purchases and eventually raising policy interest rates. This would follow the tightening of monetary policy already well underway in the US and recently threatened by the Bank of England.
At present, however, the European Central Bank continues to signal that it will maintain substantial monetary ease in the coming months, which will be a positive for eurozone equities as long as this policy stance is maintained. Other positives for eurozone equities are the strong earnings momentum, easing fears of populism, and continued robust economic growth in the markets for the eurozone's exports.
We are maintaining our eurozone positions in our International and Global Equity portfolios, while closely monitoring inflation developments.
Sources: Bloomberg, CNBC, Oxford Economics, Financial Times, HIS Markit, Goldman Sachs Economic Research