U.S. stocks at record highs. Bitcoin soaring more than 1,700% in a year. And emerging markets equities on track for their best annual performance since 2009.
After a bumper 2017 for several assets, traders can easily be forgiven for worrying about financial bubbles and questioning if 2018 can bring any returns at all. But while money managers, by one measure, are the most bearish on stocks since the financial crisis, there’s one region that’s lagged behind this year and but could outperform in 2018: Europe.
In the year-ahead outlooks from the major investment banks, the continent emerges as one of their favorite plays, with four things swinging in the Europeans favor: 1) Earnings are great, 2) the economy is also great, 3) the ECB is still super accommodative, and 4) the worst of the euro strength is in the past.
“The euro area is enjoying a period of robust and above-trend synchronized growth, across both geography and industry,” Citi said in its year-ahead report, forecasting a 17% rally for the Stoxx Europe 600 SXXP, -0.12% next year.
“While many investors worry that we are late in the cycle, Citi economists think that we are ‘either later in the recovery phase of the business cycle or early in the boom phase’. They expect a pickup in investment, which is usually facilitated by bank lending,” bank said.
2017 underperformer
But even with some stellar economic data coming out of the region lately, the Stoxx Europe 600 index SXXP, -0.12% has significantly underperformed other regions in 2017, up 8%. In comparison, the S&P 500 index SPX, -0.08% is on track for a 20% 2017 rally and emerging markets 891800, -0.12% are looking at a 29% gain.
Read: S&P 500 to crash 25% — and 9 other ‘outrageous’ analyst predictions for 2018
That’s partly because the euro EURUSD, +0.1095% woke from its slumber this year and because Europe is relatively low on tech companies, which have been a key factor in the global rally.
Next year, however, the investment banks largely expect European stocks to race past their U.S. counterparts and perform more in line with emerging markets. Here’s an overview of their forecasts.
| Bank | European stocks | Potential upside* | U.K.’s FTSE 100 | Potential upside* |
| J.P. Morgan | MSCI Europe: 1,720 | +6% | 7,750 | +2.7% |
| Morgan Stanley | MSCI Europe: 1,700 | +4.7% | 7,780 | +3.1% |
| Goldman Sachs | Stoxx 600: 420 | +7.4% | 8,000 | +6% |
| Citigroup | Stoxx 600: 460 | +17.6% | 8,200 | +8.7% |
| Deutsche Bank | Stoxx 600: 395 | +1% | 7,500 | -0.6% |
| Société Générale | Stoxx 600: 385 | -1.5% | 7,000 | -7.2% |
| UBS | Stoxx 600: 440 | +12.5% | 7,900 | +4.7% |
| Bank of America | Stoxx 600: 430 | +10% | N/A | N/A |
| Average | N/A | +7.2% | 7,733 | +2.5% |
| Compared to Dec. 19’s close | ||||
A 7.2% average forecast may not blow anyone’s socks off in a global 2017 context, but the strategists warn that the stellar returns seen this year are unlikely to be repeated in 2018.
Read: Safer and cheaper than Europe—why it’s time to jump into Swiss stocks
All hail the earnings recovery
After a long period of stagnation among European companies, there are finally signs of some serious profit growth. Forecasts of 15% earnings-per-share growth in 2017 are being thrown around, and strategists say at least 10% growth is realistic next year.
The upbeat forecasts for company profits are based on signs that Europe’s economic recovery finally has gained foothold, instilling more confidence in households and encouraging them to spend more. Additionally, companies are starting to invest more and borrow more money to expand sales.
“This [earnings recovery] is typical in what we have described as the ‘growth’ phase of the market, when earnings rather than valuation become the main driver of returns. Hence, we expect the profit outlook to be critical in determining future market returns,” strategists at Goldman Sachs said.
Read: 5 overlooked stock picks for 2018 from top fund managers
The European economy is doing great
Economists are upbeat on economic growth in Europe next year, predicting gross domestic product to rise by around 2%. That’s even a bit lower than the outlook from the European Central Bank that at its last policy meeting of the year said it sees GDP growth of 2.3% in 2018, driven by stronger business investments, exports and private consumption.
Adding to the rosy picture, the unemployment rate in the eurozone has dropped to its lowest level since January 2009 and the manufacturing PMI for the region reached a record high in December.
The robust economic growth is forecast to lead to higher yields, which is expected to be particularly beneficial for the financial sector. Within European equities, the bank strategists largely diverged in their favorite sectors, but all agreed to be overweight banks SXXP, -0.12% going into the new year.
Here are Goldman Sachs’ sector preferences for next year:
The ECB is still accommodative
But even with a roaring economy and improving earnings, the ECB is not expected to entirely remove the punch bowl next year. The central bank will buy €30 billion in government and corporate bonds each month at least until September and is widely expected to keep interest rates at record lows well into 2019.
That’s in contrast to the U.S. Federal Reserve that’s already four rate hikes into its tightening cycle and the U.K. that raised rates for the first time in a decade in November.
One thing to note, however: The ECB’s €30 billion-a-month quantitative easing program is a major reduction from the current pace of €60 billion, which reflects the improvement in the eurozone economy. Nevertheless, the ECB President Mario Draghi isn’t 100% comfortable with ending QE until inflation really takes hold and strategists therefore expect the central bank to keep its ultraloose policy in place through 2018.
Worst euro strength in rearview mirror
The euro EURUSD, +0.1095% is on track for a 12% gain against the dollar in 2017, defying forecasts a year ago that the shared currency would slump to parity with the greenback. If it ends 2017 around the current $1.18-level, it will have logged its best gain against the dollar since 2003, according to FactSet data.
The euro strength is good for all the European tourists traveling overseas, but it hurts the region’s exporters as their products become more expensive for other currency holders.
But here’s for the good news heading into 2018:
“The worst of the currency strength in terms of its impact on equities is now probably behind us rather than ahead of us,” said Graham Secker, head of European and U.K. equity strategy at Morgan Stanley.
The Wall Street bank sees the euro topping out around $1.23 in the second quarter, before sliding to $1.17 at the end of 2018. J.P. Morgan also said the negative euro impact on earnings should moderate next year, even if it expects the currency to strengthen to $1.23 by the end of 2018.
The political elephants in the room
There are risks, however, to the upbeat 2018 outlook for Europe and they are — again — most centered around the political arena.
The German election in September this year, which was seen as a walkover for Chancellor Angela Merkel, produced a murky result and the big parties are still wrangling over a coalition. Merkel’s CDU is expected to form another grand coalition with the SPD relatively soon, but the talks could drag on into 2018.
Italy’s general election in March next year also has the potential to throw European markets off course if the euroskeptic 5 Star Movement comes out strongest. The party has vowed to hold an EU referendum, which could in the worst case lead to a breakup of the eurozone. Economists, however, were relatively sanguine about 5 Star’s plans as a new electoral law in the country makes it unlikely the populist party will be able to form a government.
Read: Why Italy faces worst shock in Europe as ECB cuts bond buys in half
And then, of course, there’s Brexit. The U.K. needs to hammer out a trade agreement with the European Union during the course of 2018 and so far the two sides are wide apart. Merkel and European Commission President Jean-Claude Juncker have warned the talks are going to be difficult, while the EU’s chief negotiator Michel Barnier has thrown cold water on any hopes for a bespoke trade deal.
Meanwhile, U.K. Prime Minister Theresa may is battling with an internal party conflict at home, which skeptics believe will lead to a general election in 2018. If that happens, Labour leader Jeremy Corbyn looks set to move into 10 Downing Street and that could be bad for U.K. stocks, the strategists warned.
We “recommend staying away from the U.K. as Brexit negotiations are accelerating and several scenarios are possible: only a soft Brexit would be supportive for the FTSE 100,” strategists at Société Générale said in their year-ahead report.