Global equity markets are ending the month of November on a down note, as the recent discovery of a new variant of the coronavirus in South Africa has created new concerns. The newest variant contains an elevated number of mutations, which raise questions around both its transmissibility and its response to vaccines. The information is limited at this point and, as a result, it is premature to draw any conclusions. Nevertheless, it is fair to assume that this development will add uncertainty to investment markets, at least until more evidence emerges and scientists can assess the variant’s attributes over the days and weeks to come.
In addition to discovery of the newest variant, there has been a meaningful increase in Delta variant infections in some parts of the world. This is particularly true in Europe, which has re-emerged as the epicenter of the pandemic. Below, we take a closer look at the Eurozone, how its economy and market have fared this year, and its outlook going forward.
Understandably, the average Canadian may pay more attention to developments at home, or south of the border, than to Europe. Nevertheless, the Eurozone plays a significant role in the global economy and capital markets. It is the third-largest economy in the world, and counts China as its largest trading partner. The Eurozone and the United Kingdom together represent more than 15% of the global equity market. As we saw nearly a decade ago with the European debt crisis, developments in Europe can have a meaningful impact in global financial markets.
Europe’s economy has been in recovery mode this year, along with much of the rest of the world. Its manufacturing sector has been strong and stable, driven by steady demand for goods, while the services side of the economy benefitted greatly from being open this past summer. Despite these positives, two familiar issues present near-term headwinds. First, supply chain challenges are plaguing the region’s largest economy, Germany. Its automotive, machinery and electronics industries have not been able to meet elevated demand because of the shortages of components and supplies. Labour shortages have also been cited as an issue. In addition, the rising number of new COVID-19 infections across the region has prompted some governments to reconsider various degrees of lockdowns and restrictions, which would inevitably impact parts of the economy as we move though late fall and winter.
European equity markets have fared well this year, with returns well into the double digits. Similar to other regions, the gains have been driven by strong earnings growth tied to its economic recovery, as well as the accommodative monetary backdrop nurtured by the European Central Bank. Prior to the pandemic, the Eurozone was still dealing with the aftermath of the debt crisis, which led to subpar growth and inflation well below targeted levels. The ECB, unlike other central banks, has been steadfast in its view that monetary policy should remain accommodative to ensure a durable recovery, despite the risk of inflationary pressures.
The ECB’s messaging has proven to be reassuring for many investors, but has had some negative side effects. The Euro currency has depreciated relative to the Canadian dollar year-to-date. The decline reflects the view that interest rates will be higher in Canada over the next year, driven by a more aggressive Bank of Canada, while rates in Europe are likely to remain close to existing levels. This dynamic has driven capital flows into Canada, at the expense of Europe, and the resulting depreciation of the Euro has halved the returns that a Canadian investor would have earned in European equities so far this year.
The near-term outlook for Europe is somewhat murky, given the issues that the region is grappling with. For the most part, however, many of the challenges are temporary in nature, or have a chance of improving as we move through 2022. The longer-term drivers of equity returns, specifically the economy, earnings and monetary conditions, should remain supportive for the European market. Europe is more heavily tied to the ebbs and flows of the global economy than other regions given its dependence on exports, global finance, industrial activity and tourism. As the world increasingly gets back to normal levels of activity, Europe should prove to be a beneficiary. Admittedly, this process will take time, and there will inevitably be hiccups and bouts of uncertainty along the way (such as the new variant that has recently emerged). Investing requires patience and discipline to ride through periods of short-term volatility.
Should you have any questions or would like additional information, please feel free to reach out.
Drew Pallett LL.B., Vice-President & Director, Investment Advisor and Portfolio Manager
RBC Dominion Securities