Elections to the European Parliament in May 2019 could bring a further transformation of the political landscape. A new European Commission will follow and must contend with two significant challenges: Italy’s political situation and the future trading relationship with the U.K. (assuming Brexit goes ahead). At the macro level, there is relatively little uncertainty regarding the economic prospects for the rest of Europe. Growth slowed in the eurozone in 2018 but remained above trend. Core inflation picked up, albeit slowly. We expect both patterns to repeat in 2019. European equities have been restrained by lackluster earnings growth — especially when compared with the powerful performance in the U.S. The large financial sector has struggled in the face of ultra-low interest rates. The European Central Bank will stop expanding its version of quantitative easing but may introduce a new version of its targeted refinancing operation, which provides liquidity to banks, in order to assist Italian banks. Yet the long-awaited increase in official interest rates is now unlikely to occur before the end of 2019.
As for Italy, new elections are a possibility and the result may be a center-right coalition, which could introduce more pro-growth economic policies. This would be a positive outcome for both Italy and Europe, but getting there requires a sequence of events that remains difficult to predict.
With Brexit, we can be confident that the economic and political uncertainty will continue. A smooth Brexit is still possible but remains only one of a series of scenarios: alternatives include a no-deal Brexit or a second referendum. Yet even a smooth Brexit merely opens the way for negotiations on the future trading relationship between the U.K. and the EU. Given the arguments, regrets, accusations and resignations that have dogged this process thus far, these talks are guaranteed to be controversial on both sides of the channel.
It seems highly unlikely that Europe will be the star performer in 2019. We think core bond markets will struggle but equities should eke out modestly positive returns. “Muddle through” seems set to characterize this region for another year.