Will 2017 be a make-or-break year for Europe?

Will 2017 be a make-or-break year for Europe?

In mid-1946, Winston Churchill, in a famous speech in Zurich, called on war-torn Europe to rise from the ashes. His appeal may have foreshadowed the creation of the European Union. However, he suggested that the United Kingdom should remain outside the nascent "United States of Europe" – a prophesy strangely appropriate given the country’s recent "Brexit" decision. Today, many feel that Europe has again reached a turning point in its history. The tasks at hand are very different from what they were 70 years ago, but equally demanding.

Europe’s multiple challenges conjure up a dim picture. Anaemic economic growth, high indebtedness and structural divergence between the core of Europe and the so-called periphery are daunting enough. Moreover, they are amplified by the United Kingdom’s decision to leave the European Union and the surge in populist, anti-European political forces. Clearly, such issues are posing a threat to the European project.

Let us start with the political situation. The emergence of populist parties across the continent (the Alternative für Deutschland in Germany and the Front National in France, to name a few) or their accession to power in Hungary, Poland and Greece have a common denominator. Regardless of being right or left-leaning, all of them are "anti-Brussels". The European institutions are perceived as non-democratic, supportive of unchecked capitalism and ineffective when it comes to migration and security issues. The rise of populism is not confined to Europe as the recent US presidential election has shown. Populists generally embrace a binary view, discriminating between the "true", "authentic" members of the population – populism is derived from the Latin word populus, i.e. the people – and the "others", with that term standing for cosmopolitan, supra-nationalist and often tacit supporters of the global liberal order.

A unifying European "dream" is sorely missing
The causes for this cover the whole range from the supranational to the individual level: First, the European project lacks a "dream" – a purpose. The arguments that it has contributed to peace since 1945 doesn’t seem to carry enough weight nowadays. The "demise" of France as an alter ego in the Franco-German axis is, by default, putting too much weight on Germany, which is reluctant to lead given its history. Second, members of the European Commission aren’t elected, which invites criticism of their democratic credentials. Many European bureaucrats in high posts lack the charisma or the emotional dimension that populist leaders undeniably possess. Finally, the emergence of strongmen such as Vladimir Putin, Xi Jinping, Recep Tayyip Erdogan or Donald Trump, most of whom consider Europe as structurally weak, doesn’t help.

However, populist parties still have a long way to go. The Front National’s Marine Le Pen, for instance, is very unlikely to emerge victorious in the forthcoming French presidential election. In Germany, the established political order will most probably be preserved. Angela Merkel looks set to prevail in the coming autumn, even if she should have to govern with a grand, potentially dilutive coalition. In Italy, it is far from clear that a possible snap election in 2017 would see the Partito Democratico (PD) of former Prime Minister Matteo Renzi lose out to the protest party Movimento Cinque Stelle. A coalition between PD and the party of another former leader, Silvio Berlusconi, remains the most probable outcome. But populists will in all probability make inroads in the Netherlands, where the far-right leader Geert Wilders is tipped to win the election. However, he is unlikely to garner enough support from the established political parties to take the reins.

The situation not as dire as it may seem
Irrespective of the political landscape, the economic situation is probably better than generally perceived (see chart 1). The Brexit-related uncertainty had no visible impact on the economy so far. Growth of some 1.5 percent is again on the table for 2017. The roadblocks remain prominent, however. Lending activity in Europe still hasn’t perked up with an unfinished banking union being the main culprit. In addition, there is still plenty of doubt surrounding the capital strength of banks, particularly in Italy. A kind of silent bank run – a flow of capital from southern to northern Europe, especially Germany – is taking place, reflecting a pervasive lack of confidence in the peripheral countries of the euro zone (see chart 2). Such a situation is sure to displease the European Central Bank (ECB).

Finally euro-zone stock markets have gone nowhere since 2007, because corporate earnings – contrary to the development in the US – are still well below the peak reached in the years of 2007 and 2008. A recovery on this front may be imminent, though. Among the favourable factors is a pick-up in inflation, accelerating global economic growth and a rebound in the earnings power of badly hit sectors such as banks and energy stocks. Added to this, the euro is weak and the ECB is extremely accommodative – we only expect a first rate hike from the current zero-percent benchmark repo rate in mid-2019. This should allow for a period of two to three years of double-digit EPS growth, in our opinion. To conclude: given the political uncertainty and the still depressed earnings power, it is no wonder that global investors are underweight in Europe and the euro zone in particular. However, rampant pessimism can be a buying signal as depressed expectations can be beaten easily. Maybe the euro zone will be the surprise market of this year.