SUCCESS OF EUROPEAN BANKS NOT PREDICATED ON RATE RISES

  • UK inflation reading supports more dovish argument for a temporary inflationary blip
  • European growth rates not strong enough to prompt rate rise from the ECB
  • Politicians will be more dependent on banks to fuel economic growth
  • Italian elections have the potential to shock

Comment from Hugh Cuthbert, manager of the SVM Continental Europe Fund:

“This week’s surprise UK inflation reading points to one of the key uncertainties for European equities in the coming months. The fact that inflation has been increasing isn’t surprising given both the recent currency and oil price movements. What’s more significant is the sustainability of these moves and the subsequent policy responses we could expect should inflation really take hold. The UK reading is only one data point but it does provide support to the more dovish argument for a temporary inflationary blip and a resultant pushback for near-term rate increases.

“June’s Eurozone composite PMI came in better than expected, and even in Italy, which has long had the most sluggish economy in the area, there’s increasing evidence of acceleration in growth – as shown by the Bank of Italy’s GDP upgrade from +1.3% to +1.4% for 2017. Far from a meaningful move, and still a laggard, but at least moving in the right direction.

“Despite this encouraging news, European growth rates are still not robust enough to prompt any strong response from the ECB, meaning interest rates are likely to remain on hold for the foreseeable future. All near-term actions are likely to be directed at a tapering of the current QE programme.

“Any upward move in interest rates would of course benefit Europe’s banks, but upside in the stocks we hold (for example ING, BNP and Mediobanca) is not predicated on such an environment. Banks tend to reflect the underlying health of the economies in which they operate and as such provide cheap exposure to the resurgent Eurozone. As QE is reigned-in, politicians will be ever more dependent on banks to fuel economic growth which is likely, over time, to lead to an easing of capital demands. Not only will this help stimulate lending, it will also have a very positive impact on banks’ return on equity (ROE) and their dividend paying capability.

“There are at least two significant political events on the horizon. The German general election, scheduled for September, will result in a centrist coalition which, either left or right leaning, shouldn’t provide too much uncertainty for investors. The Italian election is far less predictable, even in the case of timing let alone outcome, and depending on the result does have the potential to shock. Particularly concerning would be a surge in popularity for Beppe Grillo’s Five Star Movement which, despite a still ambiguous policy towards the issue, may pose a threat to the country’s continued membership of the European Union. The backdrop for European equities however remains constructive, thanks to continued improvement in economic outlook, high yields compared to bonds and favourable relative valuations.”