By Mike Bird

For Europe in 2017, the big question is whether fragile economic growth and unprecedented central-bank stimulus will be overtaken by populist politics.

European equities could have a strong year if the antieuro populist candidates that have gained traction over 2016 fail to win elections, as polling suggests. But if populist candidates triumph in coming votes, the prospect of a eurozone breakup could return to markets.

Meanwhile, the world's two most important central banks -- the Federal Reserve and the European Central Bank -- continue to diverge in policy, putting downward pressure on the value of the euro. The Fed expects to lift interest rates three times in 2017; the ECB is still engaging in its massive quantitative-easing program.

The euro in December reached its lowest level against the dollar since early 2003, falling to just $1.0352. It has weakened 3.1% against the greenback this year and is down 8.8% from its peak in May. It ended the year at $1.0520.

"A weaker euro is in the interest of the euro-area economy, and pressing down on shorter-dated yields is a good way to [keep the euro weak] at a time when the Fed is moving in the other direction," said Chris Scicluna, head of economic research at Daiwa Capital Markets Europe.

A combination of a weak euro, decent economic growth and a stronger performance for banks could be just what European investors have wanted for years -- at least for those bold enough to remain in the market despite political turbulence.

In 2016, international money managers soured on Europe: In the first three quarters of the year, the eurozone suffered net outflows of about EUR405.4billion ($423.8 billion), according to ECB data.

There are good reasons to think that 2017 will offer a repeat performance: Anti-euro parties could score big wins in French, Dutch and German elections, putting the future of the European Union in question and risking a blow to the region's growth. The British government aims to begin Brexit negotiations, expected to last two years, by the end of March.

In a poll of credit investors conducted in December by Bank of America Merrill Lynch, 60% said that "a greater euroskeptic push" was their primary expectation for European politics in 2017.

Though polling suggests French far-right candidate Marine Le Pen wouldn't beat center-right candidate François Fillon in the second round of the presidential vote scheduled in May, investors are mindful of the risk of a victory for an anti-euro leader in the currency union's second-biggest economy. Ms. Le Pen has advocated that France leave the eurozone and return to the franc, and also has promised a referendum on the country's EU membership.

A Le Pen victory is "perfectly possible," according to Andrew Wilson, CEO of Goldman Sachs Asset Management in Europe, the Middle East and Africa. "It's not our central case, but I wouldn't describe it as a tail risk event.

"It would raise the question for markets, can the euro project survive? It would be reminiscent of the European debt crisis," Mr. Wilson added.

Populist candidates also are up for election in Germany and the Netherlands in 2017. But many optimistic investors note that none of the elections scheduled looks likely to produce a victory for a populist candidate. Bookmakers Betfair estimate Ms. Le Pen's odds of winning the French election at 26.7%.

"It could be that in nine months' time we're saying we dodged the worst potential outcome and ended up with center-right governments or coalitions that could bequite market friendly," said Philip Dicken, head of European equities at Columbia Threadneedle Investments.

"If earnings growth does come back in, couple that with lower valuations and better politics, and you could easily see the flows come back in," he added.

Though populist Donald Trump's victory in the U.S. presidential election in November was followed by a stock-market rally, in Europe any positive impact of a populist win on stocks would likely be overshadowed by the renewed risk of the eurozone's breakup.

Stocks listed on the Euro Stoxx index now trade at a price-to-book ratio of 1.67, considerably cheaper than the 2.8 ratio of their counterparts on the S&P 500.

Meanwhile, the eurozone economy is ending 2016 with solid, if unspectacular growth. The ECB projects eurozone GDP growth of 1.4% in 2017. The European Commission's economic sentiment index for the bloc in November rose to its second-highest level since the sovereign-debt crisis, at 106.5; the index's long-term average is 100.

Likewise, business surveys point to healthy expansion, and unemployment has dropped consistently through 2016 from 10.4% in January to 9.8% in October.

European stocks have lagged behind their American peers in recent years. While the Stoxx 600 Europe has risen by around 70% since the end of 2011, the S&P 500 has risen by more than 100%.

"Europe has been one of the biggest disappointments, but people got too negative," said François Savary, chief investment officer at Geneva-based Prime Partners "I see the scope to outperform the U.S. next year."

Write to Mike Bird at Mike.Bird@wsj.com

(END) Dow Jones Newswires

January 01, 2017 09:14 ET (14:14 GMT)

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