What next for Europe?

The European Central Bank's (ECB) decision to initiate a €60bn per month quantitative easing (QE) program was unsurprisingly well received by markets. The major indices were up at least 3 per cent since the announcement. The programme will run until at least September 2016, with central bank balance sheets expanding by €1.1trn over the period.

Although the ECB will be co-ordinating the program, the implementation will be left to each individual country's central bank. They will share the risk of loss if debts aren't repaid. Germany remained reticent throughout negotiations but ultimately, the surge of support and market expectation (markets had been rallying strongly since the beginning of the year) almost made it inevitable.

Winners and losers

Equities are a preferred asset class over bonds in this environment. Government bonds in particular are already looking fully overpriced and their yields are at historic lows. European equities on the other hand are still looking relatively attractive on a valuation basis, particularly when compared to other developed markets such as the US. Given the relative strength of the US economy and the headwinds the Eurozone still faces however, taking a long-term view could provide an attractive opportunity.

For the first time in a number of years, the Eurozone appears to have several structural tailwinds that could help boost the region's economic prospects. As a net energy importer,
the falling oil price should ultimately be positive for both the European consumer and corporations. As energy costs fall, real household incomes will increase, which should translate into increased household discretionary spend.

At a corporate level, particularly in consumer-led industries, there should be a double boost from increased spending and falling input costs. There has been a lot of discussion around the impact of falling energy prices on deflationary pressures in the region, but this neglects the fact that in the long run, it could help stimulate healthier and demand driven inflation, rather than commodity price inflation.

In conjunction with QE, it is also clear that the ECB is going to keep interest rates low for a prolonged period of time. This has had minimal impact the economy so far because banks, households and companies have been concentrating on repaying their debts. Now that many of the major banks are coming towards the end of this process and business confidence is beginning to improve, we could see an increase in lending. This could contribute to economic growth in the region.

Currency watch

As for the single currency, the announcement of QE caused the euro to plunge to an 11-year low against both the dollar and sterling. Given how far the euro has fallen, the optimal currency strategy for sterling investors is now less clear. The euro could come under further pressure given the current divergent growth trajectories and monetary policies of the UK and Eurozone. However at a corporate level, a weaker currency adds a further tailwind to earnings as exports become more competitive in the global market.

When investing in unhedged continental European funds, investors need to be aware that they are holding a basket of currencies. While the euro dominates the MSCI Europe ex UK index (accounting for 66 per cent) there is also significant exposure to other currencies, not least the Swiss franc, accounting for 20 per cent.

Following the decision of the Swiss central bank to 'de-peg' their currency from the euro, it is expected that if there is further weakness, the Swiss franc will strengthen or at least maintain strength against sterling. As such there may be an element of protection against further euro weakness within the basket of European currencies.

Although European equities
seem favourable for the reasons outlined above, significant risks still remain. Unemployment is still high, geopolitical tensions continue to periodically dominate the news and, as the Greek election has shown, the pain of austerity is causing a worrying rise in support for parties at the extreme ends of the political spectrum. There are reasons for optimism but growth is still embryonic and the path to recovery is likely to
be bumpy.

Ben Palmer is an investment manager at Brooks Macdonald

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