Investors need to avoid getting overexcited by growth prospects in Europe as there are still some clouds on the horizon, according to Old Mutual’s Ian Ormiston.
The manager of the Old Mutual Europe (Ex UK) Smaller Companies fund said despite Europe’s outperformance this year, investors should remain wary.
In 2017 the MSCI Europe ex UK has returned 16.68 per cent, rising strongly in the first six months of the year before stalling in more recent months.
Performance of index over YTD
“At the start of this year everybody came in panicking about Marine Le Pen quite rightly because we had these two outlier events in the UK and the US and there is definitely a growing disaffection in France with the centre,” Ormiston said.
“Now obviously it manifested itself in a different way with Macron but it was clear that anyone outside of Europe was worried to death about that tail risk and probably more than they should have been.”
An improving political situation with the election victory of Emmanuel Macron has been coupled with strengthening macroeconomic data, which has boosted European equities this year.
“At the same time the macro has been improving across Europe, including France, for 18 months or so,” the manager noted.
This was reaffirmed by the most recent gross domestic product (GDP) figures, which showed quarterly growth edged up from 0.5 per cent at the start of the year to 0.6 per cent in the second quarter.
Meanwhile year-on-year growth leapt to 2.1 per cent from 1.9 per cent, but Ormiston said these figures can be misleading.
“It drives me nuts when people annualise a quarterly GDP number, we could multiply a weekly number by 52 and say the annualised growth rate is amazing,” he said.
“The fact that Europe was growing faster than the US and the UK was reported in the UK because it makes a great UK narrative – the UK been hit by Brexit uncertainties etc – but the truth is that if Europe grows at 2 per cent it will be at productive potential.
“I don’t want to say it’s really bad but at the same time my big message to people is not let’s get overexcited. I really worry that people are now going out with the idea that Europe is the hotspot.”
Indeed, as the graph shows, the market has stalled in recent months and Ormiston (pictured) points to a peak in positive surprises from macro factors that have dulled the market. 
“Just as the French election goes the right way as far as markets are concerned you pretty much simultaneously hit the peak in terms of positive surprise,” he said.
“So the surprise season has rolled off ever since Macron got elected because as good as it gets for Europe is about 2 per cent real GDP.”
This is not to say that Europe is not an attractive area for investors, however, just that investors need to temper their expectations.
Indeed Ormiston noted that unlike other times in recent years, the growth seen in Europe appears to be self-sustaining.
“In terms of the self-sustaining nature, it is there. It is not being driven by austerity anymore, which is great, it is being driven by credit creation which is real. Actually we are starting to see lending growth even in Italy,” he noted.
“Rhe non-performing loans (NPLs) are finally starting to fall and those NPLs are beginning to be shifted off balance sheets, so even though it is not in the headlines it is good and healthy that the banks are being fixed.”
And this time, the biggest driver for growth has been employment growth (falling unemployment) and growing consumer confidence.
“So it is not a traditional European recovery,” the manager said. “The export sector is traditionally the driver for growth because Europe is always slow and then it gets pulled into Asian growth or US growth.
“This time the export sector has been okay but not been the major driver.”
However, Ormiston said that while it has different factors this time, it remains “traditional European growth” in that it is not fast.
And there are a couple of clouds on the horizon that could cause problems for investors – including the exporters.
“The thing that I would flag as a potential risk is the strengthening of the euro which at 1.18 is not causing any major problems,” he said.
“There has been a bit of translation for the overseas earnings sector in Q2 reporting but it is not until we are probably up towards 1.30 that we will start to really hear bleating from the export sector.”
Performance of euro vs dollar over YTD
Indeed, the euro has strengthened 11.55 per cent against the US dollar so far this year, as the above shows.
The other issue for investors to keep an eye on is the potential for deflationary pressures to re-emerge, something that has become less of an issue in recent months as inflation has picked up, but had dominated headlines previously.
“[European Central Bank president Mario] Draghi has spent a lot of money trying to engineer a bit of inflation but we are going to get another wave of deflationary impulse – kind of the opposite to what we have seen in sterling – because oil prices which is the big import into Europe are going to fall again as the euro strengthens against the dollar,” the manager explained.
“So there is nothing you can do about that and the ECB will talk about underlying inflation not being impacted by it but if people don’t believe in inflation – if there are no inflation expectations – funnily enough we won’t get any inflation.
“In an ideal world we would have 2 per cent real GDP and we would have 2 per cent-ish inflation but there is a risk that we are not going to get that.”
Overall, however, the manager said that the macroeconomic data is fine and the political issues are largely behind Europe – though Italy remains an issue.
“Five Star are still leading in the polls and we do need to have an election before next March so I think there will be definitely sentiment wobbles around that,” Ormiston said.
“I think there will be market volatility around the election but does that undermine the macro? I don’t think so at all.”
The next thing for investors to see on the positive side of things is company re-investment, which could help to boost growth and reduce the risks mentioned above.
“We are probably reaching a stage in the cycle where companies need to start investing for the first time because all that excess capacity that still hasn’t been used since the start of the crisis.
“It is amazing that we still have so many industries that are running 10-20 per cent below their peak levels so actually there is plenty of mothball factories capacity and obviously labour capacity.
“As we see that coming through we should see some sort of investment driven growth because most investment at the moment driven is internet or electric car technology driven, so it is future investment rather than capacity investment for the time being.”