Eurozone: What’s the Story After Brexit?

The Brexit result opens a new period of uncertainty for the future of Europe. The hit on consumer confidence and economic growth is expected to weigh on the profitability of European companies, where sectors are expected to be impacted by difference factors. Spillover can be through the financial sector, trade, foreign direct investments and migration flows, as highlighted by the chart below.

Going forwards we see two possible scenarios for the evolution of the European economy. One is a “Bad Path” in which the uncertainty will continue to put in doubt the prospects of the European project with the consequence of highlighting any kind of fragility, such as the European banking sector, and causing renewed fragmentation. The other is a “Good Path” in which uncertainty will be temporary and will be followed by a recovery period in which things start to work smoothly.  Under these two scenarios our GDP growth forecasts change materially, especially in 2017 and 2018.

At the moment, we see rising risks for a negative scenario materializing. The electoral cycle in Germany and France next year and the Italian constitutional referendum this year may drive the focus more towards domestic issues and less in the direction of further European integration. We believe that the evolution of the European situation will also be crucial for the DM outlook in 2016 and 2017.

In this environment, we believe that the European Central Bank will continue the Quantitative Easing program, possibly reviewing it with an eye towards a more accommodative basis in terms of duration and size.

The economic implications of Brexit on the Euro Area will be related to growth and possible tightening in financial conditions, which could materialize starting from the second half of 2016. As a result, our outlook on the profitability of European companies is deteriorating with a forecast reflecting an expected decline in the Earnings per Share (EPS) growth, now significantly lower compared to the US and Emerging Markets.

From a multi-asset perspective, with lower profitability growth and higher volatility due to political uncertainty, we prefer to keep a cautious allocation on European equities in this phase. Our approach will be focus on both goals of mitigating volatility and selecting appropriate stocks.

Given the further decline in European government bonds yield, this asset class looks unattractive, both compared to US government and EU credit markets. As government bonds are set to remain at very low or even negative yields, the ECB action could be more oriented towards corporate bonds. In our view, monetary policy supports a positive bias towards European corporate bonds. In fact, the European corporate bonds market is expected to continue to benefit from ECB bond purchasing program support, making European credit attractive.