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Road to 2020: part 2

This is the second part of the five part 2020 investors' questions series.


2. Is the Eurozone economy heading into a recession?


Recent developments

Eurozone PMIs are on a downward trajectory and we are likely to see another weak quarter as we end 2020. Manufacturing index keeps extending downwards and auto sector has been deeply hit by the political uncertainty and slowing exports. Services, which were showing some resilience are also starting to show slow growth, and this only means we can expect a lower than expected growth in 2020 for the EU. In September, ECB provided more stimulus to the markets by implementing another 10bps rate cut and a reintroduction to quantitative easing. Considering we are already in the negative territory of interest rates, it will hard to see how effective this strategy will prove to be.

Our view

Base case (50% probability) – Economic growth remains relatively flat

We give the highest weighting to our base care scenario, which assumes ECB will continue to do everything to make sure GDP growth stays positive. While uncertainties over Brexit and global trade will continue to hit the likes of export-dependent industries such as the German automotive industry. We expect domestic demand to hold up along with the services sector given ECB will likely support the economy by keeping interest rates lower for longer from which we can expect high consumer confidence, rising property prices and a low unemployment rate. In this scenario we assume that the US-China situation will not go beyond the disclosed tariffs and the Trump administration will eventually decide against car duties. We also don't expect a further deterioration in the growth outlook that would significantly raise the risk of a recession. It is worth nothing that Germany is clearly at the risk of recession but we can expect the German government to adopt moderate fiscal measures to support the slowing economy.


Downside scenario (35% probability) – Global economic slowdown We believe there is a decent chance of a further deterioration in the China-US trade dispute, beyond what has been disclosed in terms of tariffs. In a scenario, where the two countries enter into a tit-for-tat tariff war, EU is highly likely to tip into an economic recession over our investment horizon of 6–12 months. The German economy is already operating at a high risk of recession and anymore slowdown in global growth will quickly move the country into a negative GDP growth zone, while the more resilient countries will see much more weakness.


We believe the ECB is already operating will little room to play the stimulus game, and in such a scenario, it will face extreme pressure if it has to cut rates again, or expand the QE program to other asset classes such as asset-backed securities and equities. Fiscal packages can only be announced for countries with low debt to GDP like Germany and Netherlands, but that would also mean these countries will have to suspend any austerity policies as per the EU rules.


Upside scenario (15% probability) – External headwinds fade

There is no surprise that US-China trade talks are also the highlight of our upside scenario. Given the export dependency of the region, any reduction in trade tensions or fading threat of duties against European cars will cause a definite rebound in EU economic growth above expected levels. This will improve be pushed further by better domestic demand, a brighter outlook for the manufacturing sector and continued ECB stimulus. In this scenario, we also assume a decent agreement between the EU and UK regarding Brexit with the risk of a no-deal departure close to none.

Conclusion

Overall, if the Eurozone economy enters a recession, we would expect Eurozone equities to fall by 10–15%. Lower-rated peripheral countries, such as Italy or Spain, would suffer from the higher risk premium demanded by investors. German Bund yields will likely touch new record lows (they are already in the negative territory). And we can expect the Euro to depreciate against the USD to somewhere near 1.05 through 2020.


In our upside scenario, a brighter outlook for the European economy and a rebound in the manufacturing sector would support corporate earnings, which could mean EU equity markets rising up to 10%. The outlook for the euro would depend on future ECB decisions, but if the markets start to price a tightening of monetary policy, EURUSD could reach 1.20 in 2020.


S. Khan

Head of Investment Research



© 2019 by Acinox

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