Europe's accommodative monetary policy isn't going away anytime soon

The 2017 political calendar is busy, with general elections in Germany, France, and the Netherlands, and a strong likelihood of an election in Italy.

In our view, this packed schedule and the rising support that populist political parties have recently leveraged is likely to prevent eurozone leaders from implementing reforms that are urgently required for the currency union to produce economic stability, prosperity, and convergence. This lack of progress leaves the region inherently fragile, makes episodic crises likely, and ensures the policy response will be underwhelming and consistently “too little, too late.” For example, the Italian bank crisis and Greek debt saga have festered for years, reflecting the eurozone's preference to “extend and pretend.” A further obstacle to economic growth is the reluctance of eurozone leaders to pursue fiscal stimulus policies similar to those that the United States, Japan, and other developed economies have implemented.

The ascendancy of populist parties and the declining support for European institutions can be traced to weak growth, in our view. Industrial production is well below its 1999 level in many European countries, with Germany the notable exception.¹ The story has been similar regarding the eurozone's GDP, with Italy being the biggest loser; its economy has barely grown since the common currency was introduced in 1999.²

While growth has been sluggish across much of the eurozone, countries' productivity gains have diverged. Italy has been a laggard, while Germany has posted productivity growth in the 0.5% to 1.0% range.² One manifestation of this divergence is Germany's huge current account surplus, a measure of the value of the country's net foreign assets, or assets less liabilities. Boosted by a relatively cheap euro and historically low interest rates, Germany's current account surplus has soared to 8.8% of GDP, dwarfing China's 2.4% and Japan's 3.7%.² Clearly, Germany's export machine has reaped great advantage from the weak euro, while many other EU nations, such as France, Italy, and Spain, have sustained current account deficits.

Amid slow economic growth, weak domestic demand, and high unemployment, we expect the eurozone's core inflation rate to remain well below the European Central Bank's (ECB) 2.0% target for several more years. To date, the ECB has implemented the most accommodative monetary policy of any post-World War II developed economy, and it remains under great pressure to stimulate growth as a result of the eurozone's overly tight fiscal policies and lack of progress on key reforms. We expect that the ECB will act extremely gradually when it finally sets out to normalize its policy, and that it is likely to maintain an accommodative stance well into 2018, even as the U.S. Federal Reserve (Fed) raises rates.

If the ECB maintains an accommodative approach and the Fed continues to hike rates, we expect the U.S. yield curve will rise relative to Europe's, placing downward pressure on the euro currency. Additionally, we expect that U.S. economic growth will exhibit a moderate degree of cyclical lift next year, while Europe's economic growth holds steady. Together, these views suggest that U.S. financials sector stocks, domestic cyclical stocks-those most sensitive to changes in economic trends-and small-cap U.S. stocks are likely to outperform their counterparts in Europe. In this environment, defensive and interest rate-sensitive sectors in Europe's equity markets may outperform other European market segments, in our view. Additionally, we believe there is a strong investment case for stocks of European-based multinationals, especially those that generate free cash flow and possess superior management teams with competent capital allocation policies.

1 European Commission, 2017.

2 The World Bank, 2017.