Welcome to the Neurozone

Some seem very bullish on the eurozone’s economic improvement, but overall, we think investors shouldn’t be quite so optimistic. Source: Jeff J. Mitchell/Getty Images

Eurozone Q2 2013 GDP was published Wednesday, and for the first time in six quarters, the region returned to growth at a 0.3% q/q rate. Headlines seem pretty happy the region’s longest recession ever is over—at least for now. But we’d suggest tempering enthusiasm—while the end of the eurozone’s recession could be an incremental tailwind for global stocks, we think it’s premature to feel wildly bullish about eurozone stocks.

Economic conditions are important for future corporate profitability, but they aren’t the be-all-end-all of equity returns—political developments and investor sentiment also drive prices. While the eurozone may improve economically (incrementally) and sentiment might be a bit too dour, the region potentially faces years of political uncertainty, which could weigh on investment and, by extension, future earnings.

At the moment, the very structure of the eurozone (and the broader EU) looking forward is up in the air. Institutional and national leaders have agreed in principle to form a regional banking union, but they’re still trying to determine its scope and regulatory scheme. Fiscal union—including common Eurobonds—and political union are also under discussion. These are big potential changes and likely require treaty changes, which is no small task. The eurozone is currently governed by the full EU treaty, so all 28 EU members will have to agree to each amendment (or a new treaty). Getting 28 nations with competing interests to agree on the finer points of a new political system could take years—just as previous EU treaties have taken years to hash out. And once the agreement is reached and signed, each national parliament must ratify it, and nations like Ireland and (potentially) the UK must hold referendums. An overnight solution doesn’t exist—this will be a long, arduous process with lots of potential for hang-ups.

Plus, to achieve more sustainable growth, peripheral eurozone countries still need deep structural reforms. Progress on this front has been bumpy thus far, and with political gridlock persisting, the pace probably doesn’t accelerate. For one, Italy’s notoriously shaky coalition isn’t even pursuing much-needed labor reforms, and meaningful measures likely won’t pass unless the byzantine electoral system gets reformed so voters can elect a stable government. Portugal's coalition is similarly tenuous, Spain's administration is distracted by scandal, and Greece is Greece. On balance, the current governments seemingly lack the clout to pass sweeping series of politically unpopular items like public sector and budget cuts, labor reforms and other measures necessary to free up private sector potential. Reforms likely come in fits and starts for a long while—another possible drag on equity prices.

This is also likely a drag on the economy—at least in the periphery. And with pockets of strength and weakness persisting, growth could well remain choppy—one quarter’s positive data doesn’t necessarily signal a trend. Now, if the global economy were to strengthen further, perhaps that changes—cyclical factors can trump structural issues if they’re powerful enough and the globe could easily pull the eurozone up faster. But we’re four years into economic expansion, and we don’t think that degree of persistent acceleration is very probable in the immediate future. That’s not to say the eurozone’s return to economic growth should be dismissed—incrementally improving economics could lift sentiment—but other drivers likely outweigh. Global investors can probably find better opportunities elsewhere.