A muted narrative surrounding the region has become received wisdom for investors, yet this “cool to be cautious” mentality is increasingly at odds with both fundamentals and the direction of markets. This started to become apparent in the latter half of 2016. Both the U.S. Presidential election in November and the Italian constitutional referendum in December did not result in the outcome that many expected, but in both cases the market reacted positively to what might have been deemed “bad news”. The behaviour of markets is never easy to predict, but it appears that investors may finally have begun to become desensitised to the political concerns that have dominated the column inches since the beginning of the financial crisis. In market parlance, the bad news is simply now “in the price”.
Nowhere have these worries been more acutely felt than in Europe, as investors in the region we have become accustomed to pushback. Whilst Europe has some excellent, attractively valued companies based within its borders, the political situation and the lack of consensus about the future of the economic and currency union has made it an easy region to avoid for many international investors. Against such a backdrop, it is unsurprising that some have been wrong footed by the sharp rise in European equity markets in the first five months of 2016. In Euros, the MSCI Europe Net Total Return Index is up almost 9.5% to the end of May. In U.S. dollar terms this increases to an impressive 16.5%. Low expectations aside, economic activity in Europe continues to gather strength. IHS Markit recently reported that their Eurozone Manufacturing Purchasing Manager’s Index rose to 57 in May, the highest level for six years. Buoyed by growing exports and strong demand at home, employment saw the biggest increase in the 20-year history of the survey. Furthermore, this expansion is broadly spread, with all countries participating. Consumer confidence indicators are equally robust.
Throughout the crisis years, we advocated Europe for the quality of its companies. Strong corporate balance sheets, high dividend yields and best-in-class corporate governance all formed part of the appeal. Undeniably though, the missing ingredient has been sales and earnings growth, particularly when compared to their U.S. counterparts. Here too, we feel the winds of change begin to breeze through markets. According to JP Morgan, European stocks recorded sales growth of 10% and earnings growth 23% in Q1 2017. Consensus forecast for full year earnings growth have risen to mid-teens levels. As we move forward, it is worth bearing in mind that European companies have spent years cutting costs. We sense that there is a significant amount of operating leverage to come through if sales continue to accelerate. After years of stasis, Q1 2017 may only be the beginning.
All of this coincides with a time where there is a strong valuation case for Europe. Barclays Capital estimate that on a cyclically adjusted, the PE ratio, Europe has not been this cheap versus the U.S. since the mid 1970’s. This is largely a function of depressed profitability. Return-on-equity and profit margins are running at around half the level of those achieve by U.S. corporates.
This valuation starting point and sheer strength of economic recovery means that European equities are an attractive place to invest right here and now.
Nevertheless, prudence dictates that we should be cognisant of the risks which could derail the current rally. The election of Emmanuel Macron as President of France was ultimately a benign outcome for markets and went some way to allaying Eurozone break up fears, but at some point these concerns are likely to emerge again. There will be an Italian general election in the spring of 2018 where the Eurosceptic Five Star Alliance currently lead the polls. Other challenges also remain. Debt renegotiations in Greece will take place over the summer and Brexit negotiations are likely to prove contentious. Furthermore, investors will have to face up to the prospect of the ECB tightening monetary policy, a shift which cause the now infamous “taper tantrum” when it occurred in the U.S.
The path to success as an investor is to look forward rather than backward and try and focus on what really matters. Our current conviction is that this centres on strong economic growth and its implications for companies. For Europe it is finally about earnings and not elections.
Senior Portfolio Manager - European Equities