Europe rising

Confluence of catalysts supports Euro assets

Donald Trump’s tariff focus has now turned towards Europe. Just as investors were beginning to exhale after the pause on reciprocal tariffs and de-escalation with China, the U.S. President issued fresh threats of a 50% tariff on EU imports (as well as 25% tariffs on imported devices made by Apple and Samsung). In characteristic on-again-off-again fashion, the implementation of the 50% levy was delayed to July 9 from June 1 shortly thereafter. Previously, the EU had been hit with a 20% reciprocal tariff, which was subsequently paused and lowered to the “universal” rate of 10%. With the European economy (and equity market) having a relatively high degree of trade-sensitivity, how do these latest threats shift the macro outlook?

In the past, we have noted the myriad headwinds impacting the European economy and financial markets, which have become well-known by the market. Since the Global Financial Crisis, European stocks have notably underperformed their U.S. counterparts. The sovereign debt crisis in the early 2010s impaired Europe’s recovery, while the value-orientation of European stocks significantly lagged the stellar returns produced by growth stocks during the period. Europe’s financial sector was forced to deleverage, and in the process gave up considerable international market share to their U.S. peers. Political fragmentation, exemplified by Brexit, and limited progress on fiscal harmonization across EU member states further complicated matters. More recently, Europe has had to contend with a major war on the continent, energy security concerns, a protracted slump in the German manufacturing sector, and China’s rise as a formidable competitor in a growing number of industries.

With such a downbeat mood overhanging European assets, there was a very low bar for “upside surprises” that could help them re-rate higher. Numerous positive factors have materialized in recent months. The German election helped reduce political instability and led to a major fiscal pivot from the nation known for its strict austerity. The EU introduced a clause to exempt defense spending from fiscal deficit rules and announced fresh spending of their own.

Per the chart below, Euro Area loan growth is now accelerating for both households and businesses. Banks’ strong capital positions are fueling buybacks and M&A activity, while a positively-sloped yield curve supports net interest margins. Southern Europe has deleveraged and is growing without systemic imbalances.

The European Central Bank is amidst a rate cutting cycle, and energy prices have eased, taking the heat off Europe’s import bills. Despite the elevated volatility this year, European stocks have quietly surged approximately 15% in Canadian dollar terms.

Additionally, there are several catalysts that would further support European assets. The potential end to the war in Ukraine would decrease geopolitical risk, while rebuilding battered Ukrainian infrastructure would be lucrative for European industrials. A continued repatriation of capital from the U.S. back to Europe would boost liquidity and domestic asset prices. European investors have done extraordinarily well on their U.S. investments and may seize on the opportunity to rebalance their portfolios as U.S. policy concerns and a weakening “U.S. exceptionalism” narrative stay top of mind.

Merging the improvements in the European investment case with the quickly-changing trade conditions is no straightforward task. Undoubtedly, U.S. tariffs would weaken Europe’s economic trajectory. But counterintuitively, the more hostile the U.S. administration gets, the more accommodative European monetary and fiscal stimulus will likely become, offering a critical counterbalance to the equation. Despite the elevated risks and uncertainty, we expect European stocks to continue to outperform.

Here’s a top-line summary of our asset strategy.

Cash and currencies. Despite falling domestic short rates, cash remains a viable source of portfolio stability during market turbulence. However, instead of solely holding excess cash to offset equity risk, we have elected to implement a diversified approach of cash, increased (and longer duration) fixed-income allocations, and gold. Cash has been increased modestly in client portfolios.

Bonds. Our U.S. bond strategy has maintained a long credit, short-duration positioning in recent years. The investment case for this positioning has weakened of late, as on-and-off tariff impositions are fueling business uncertainty, and attempts to rein in the U.S. government deficit have weakened the fiscal tailwind. U.S. bond duration has been increased back to benchmark in client portfolios.

Equities. Fiscal policy is a key theme in China, as increasingly aggressive stimulus measures are critical to pulling business and consumer sentiment out of a protracted slump. While China has thus far been a primary target of U.S. tariffs, industrial policy implemented since the first Trump presidency has greatly improved the nation’s resilience. A position in onshore Chinese “A-share” equities has been added to balanced and growth-oriented strategies this quarter.

Opportunities. Countries in Latin American are viewed as less trade-sensitive relative to Emerging Market peers, have high real interest rates (which provide monetary policy flexibility and support their currencies), and offer compelling valuation multiples. Positions in Chilean and Brazilian equities have been star performers year-to-date, despite headwinds from trade uncertainties.

Visit the Forstrong Insights page to stay informed on our global macro thinking and strategy updates.

David Kletz, CFA, is Vice President and Lead Portfolio Manager at Forstrong Global Asset Management. This article first appeared in Forstrong’s Insights Blog. Used with permission. You can reach David by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at dkletz@forstrong.com.

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