It’s commonly recognised that the Eurozone economic cycle is lagging that of the US by roughly three years. Despite the clear parallels, investors appear to be heedless to the lessons learnt about the US over that time.
Notable amongst these lessons has been the proclivity for the US Federal Reserve to be caught on the hop, specifically in their economic projections. The US economic surprises weren’t so much around headline growth; the Fed’s 2014 prediction that 2017 growth would average about 2.4 per cent looks downright prescient today.
It was elsewhere that things went awry. Three years ago the FOMC predicted the unemployment rate would have reached 4.9 and 5.3 per cent by 2017. Based on its estimate at the time, this was close to its assumed long-run equilibrium level. Predicated on the faulty assumption of the unemployment rate returning to equilibrium, the Fed forecast that the Federal funds rate would also return be restored to equilibrium – a rate of roughly 3.75 per cent, according to the ‘dot plot’ at the time.
Of course, the reality has played out rather differently. Indeed, a curious combination of much tighter unemployment and looser monetary policy has prevailed (the latest unemployment rate is 4.1 per cent and Fed funds is being held in a range of 1.25 to 1.5 per cent).
It turned out that the US economy could operate at a significantly lower than expected rate of unemployment, somehow without delivering undue inflationary pressures.
No one really knows exactly why US wage growth has languished in the doldrums. The mystery of why a booming economy hasn’t produced fatter paychecks has given rise to a whole host of theories. Two of the most plausible explanations (on top of global forces) are that: there is ‘hidden unemployment’ not captured in the headline rate; and older workers, on lower average pay growth, are staying in employment for longer and depressing aggregate pay growth.
These factors are likely to play an even greater role in muddying the relationship between European unemployment and wage growth. The headline rate of unemployment could grind to a very low level by historical standards with very little upward pressure on wages.
Much as there were in the US, in Europe there are signs that a relatively high proportion of workers with jobs would like to be working more hours. But the most interesting component of the story is the people on the fringes of the labour market being enticed back into gainful employment.
The participation rate in many European countries is currently still extremely low. In France roughly 56 per cent of adults participate in the jobs market in some way, compared to 63 per cent of the adult population in the US. Germany has a rate higher than its continental neighbours (61 per cent) but still well below the US. In Italy the participation rate is less than 50 per cent.
The difference is most stark in the older age categories. In the US nearly 20 per cent of over 65 year olds work compared with 7, 3 and 4 per cent in Germany, France and Italy respectively.
But a pressure to join the labour force is mounting, from all directions, for all age groups. Bloated government balance sheets and a push for social reform are contributing to incrementally siphoning what were once generous benefits. One example is public and private early retirement schemes, which are being phased out.
The conventional view – that Europe has poor demographics – misses this untapped potential workforce entirely.
The key lesson is that the headline rate of unemployment is profoundly misleading. This traditional indicator is a poor gauge of limits to growth or incipient inflationary pressures – and this will be even more of an issue for Europe than it has been for the US.
European firms are likely to be able to bear down on wage pressures for some time. If robust global demand means they regain some top line pricing power, then the scene is set for an expansion in corporate margins.
Meanwhile the ECB is likely to be troubled by wage growth that remains too low to be consistent with their close to but below 2 per cent inflation target. They are likely to fret over the possibility that inflation has got stuck or de-anchored. Whilst they may still feel it appropriate to cease adding to their balance sheet over the course of 2018, the prospect of ‘normalising’ interest rates shortly after seems remote. Whether investors are listening or not, the lessons of the US economic cycle are writ large for Europe – robust growth, low cost pressure and loose monetary conditions could well fuel risk assets, for far longer than one might imagine.
Our assessment is that this good news is not incorporated in either analysts’ forecasts for earnings or valuations. Earnings for MSCI Europe ex-UK are expected to grow at roughly 10 per cent next year, the same as last. The combination of better margins on top of a higher volume of sales should lift earnings next year.
Better earnings alone will support equity prices and we could even see a re-rating of European equities if better earnings coincide with reduced political risk. Price to earnings ratios have scope to move higher as they already have in the US and the case for European equities looks compelling.
Karen Ward is chief market strategist for the UK and Europe at JPMorgan Asset Management.
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