3 reasons for investor optimism despite European turmoil

The political upheaval in Spain follows an even more fractious time in Italy but neither suggests a European Union breakup is imminent, and may present opportunities, say analysts from Fidelity, Insight and AMP Capital.

Socialist Pedro Sanchez was sworn in as Spain's Prime Minister on Saturday following the ousting of former leader Mariano Rajoy. Sanchez, the seventh Prime Minister of Spain since the end of the Franco dictatorship in 1975, is the first premier to come to power without a national vote for parliament.

Spain's new socialist leader Pedro Sanchez and his predecessor Mariano Rajoy

The reshuffle was triggered by a case involving Rajoy's centre-right People's Party, in which former PP members received jail sentences this month for their part in a long-running kickbacks scandal.

The turmoil comes just days after Italy's failure to form a stable government shook global stock markets.

Fidelity bond investor Andrea Iannelli expects the uncertainty in peripheral Europe to continue and doesn't rule out further elections.

"Despite the changes at the helm, there is very little that the new Spanish government can actually do," Iannelli says. "The government that Sanchez now leads has a very slim majority in parliament and relies on the support from parties with very different political agendas. As it stands, in the short term it is difficult to see how long the new government will hold, and early elections appear likely in the months ahead."

However, Iannelli says Spain is in a stronger position to Italy and more pro-Europe - two reasons why investors will view its political two-step in a different light to the turmoil on the other side of the Mediterranean.

"Firstly, in Spain there is much more support for Europe across the political spectrum and among the population, which should prevent a replay of the sparring and anti-Euro headlines that weighed on Italian assets in May," he said.

"Secondly, Spain is in a stronger position, both on the economic and fiscal front. The country implemented structural reforms, benefits from a structurally higher level of growth and has a lower debt to GDP ratio than its Italian counterparts."

Asset manager Insight Investment agrees. In a note, it says the change of government in Spain poses less of a systemic threat to the eurozone than Italy because of a combination of "stronger economic growth, better public debt dynamics and a pro-European bias to its political setup".

No reason to fear eurozone break-up

AMP Capital chief economist Shane Oliver admits "Italy is a worry" but he sees little reason for investors to fear the eurozone is about to break up.

First, the majority of Italians support the euro, Oliver notes, despite overall levels of support failing to match those in other member countries.

Secondly, as other near misses in recent years have shown, exiting the eurozone "is easier said than done".

And third, "the risk of contagion to the rest of the eurozone is far less than it was earlier this decade," Oliver says, noting the relatively good shape of "other vulnerable countries like Ireland, Portugal and even Greece".

Oliver notes that investors will have a clearer idea on the future once the populist, Eurosceptic coalition government properly outlines its plans.

"While a break-up in the euro is unlikely, a populist coalition in government in Italy, which is the eurozone's third largest country, along with a deterioration in its budgetary position will keep fears of a threat to it alive, after they subsided following last year’s elections.”

Oliver sees positives in Europe, particularly as growth remains reasonably healthy and there is no immediate threat of rate rises.

Eurozone shares too are attractive, says Oliver. They aren't overvalued and are trading on a price to forward earnings multiple of 14 times, which is around its long-term average, he says.

Their cyclically adjusted price-to-earnings ratio, which compares share prices to a ten-year moving average of earnings (often called a Shiller PE) is about 17 times compared to 32 times in the US.

"This is largely because eurozone shares underperformed US shares in the post-GFC period. Adjusting for relatively lower bond yields in Europe makes eurozone shares even more attractive," Oliver says.

"Second, the European Central Bank is still pumping cash into the economy and is a long way from rate hikes. Italian risk may keep it easier for longer. This contrasts to the Fed which is engaging in quantitative tightening and raising interest rates.

"Third, the euro is now falling. A rise in the euro through last year - as eurozone growth surprises on the upside relative to the US and political risk declined in the eurozone relative to the US - harmed eurozone shares. This is now reversing as US growth has started to accelerate relative to the eurozone," he says.

Though eurozone growth has slowed a bit, Oliver says it's still good. "And thanks to ongoing monetary stimulus and a now falling euro, is likely to remain so. In turn, this is good for profit growth".

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Glenn Freeman is senior editor at Morningstar Australia.

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