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European equities, weighed down by political concerns, have appeared undervalued for a year. However, with political risk fading and the euro zone economy simultaneously strengthening, that could be set to change.
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The UK referendum result was the catalyst for many investors to pull money out of European equities on what they perceived to be mounting political risk ahead of a slew of European elections this year. While that risk has not completely dissipated – votes are due to take place in Germany later this year and more significantly, potentially Italy too – there is far less concern now the French election is out of the way.
At the same time as the political clouds have started to lift, the European economy has begun to grow at a healthy clip. Not only did the euro zone post faster annual growth than the US for the first time since the financial crisis in 2016, it has continued to outperform.
Economic output expanded at an annualised pace of two per cent for the second successive quarter in the first three months of 2017 – the fastest pace of growth in six years.1 Encouragingly, stronger growth has driven a steady rise in employment, with the number of people out of work standing at 9.5 per cent in March – an eight-year low – down from 10.2 per cent a year earlier.2 Furthermore, more up-to-date economic indicators, such as the closely watched monthly purchasing managers’ reports, suggest there was no let-up in the pace of expansion at the start of the second quarter.
Faster growth has already started to feed through into corporate results. To date, 61 per cent of the companies within the Eurostoxx index to have reported first-quarter results have beaten analysts’ expectations. In turn, and in marked contrast to what was seen during the previous six years, that has prompted analysts to upgrade their earnings forecasts as shown in chart 1. However those upgrades have to date been comparatively modest. Although analysts are forecasting companies will deliver annual earnings growth of 20 per cent in 2017 and 10 per cent in 2018, this represents just a two percentage point upgrade from the growth rates they were predicting at the start of the year.3 And while the figures may look respectable, it should be remembered that they come off a low base with earnings having declined in 2016.
Since forecasts naturally tend to lag company results, we believe we are likely to see further upgrades coming through as analysts respond to the unexpected strength of first-quarter numbers. Those upgrades should in turn help to underpin further gains in equity prices.
With company results beating expectations and political clouds lifting, we see scope for a big increase in investment flows into European equities. Although investors have recognised the outlook for corporate earnings has been improving for some time, flows into European equities have been held back by political uncertainty. As seen in the chart below, investors were large net sellers of European equities in the second half of 2016 and the start of this year, largely as a result of rising political uncertainty. While that trend has begun to reverse, thanks in large part to a perceived drop in political risk following Dutch and French election results, net outflows over the past year remain significant.
Although European equities have risen sharply in 2017, with the Eurostoxx index returning 9.55 per cent in the five months to the end of May, there are strong grounds for believing they remain undervalued. Not only have company earnings beaten expectations, economic data improved and political risk emanating from individual countries declined; but with the election of Emanuel Macron as French president there are signs that the European Union could take steps to improve the functioning of the euro zone.
Under Macron, France could embark on the kind of wide-ranging reform of its product and labour markets that Germany undertook under former chancellor Gerhard Schröder fifteen years ago. The belief is that this could in turn give renewed impetus to closer European integration, particularly if other countries, most notably Italy, were to be persuaded of the need to make similar reforms. Already there have been encouraging noises coming from Berlin about how it would respond.
Following a meeting with Macron on May 14, German Chancellor Angela Merkel indicated she would look to push for further integration of the euro zone. And even her hard-line finance minister hinted that his opposition to Macron’s plans for deeper economic co-operation was not as stiff as many suspected. When asked if Germay should divert more of its budget surpluses to southern Europe, Wolfgang Schäuble told news weekly Der Spiegel there was a need for transfers between wealthier and poorer EU states.4
“A community cannot exist without the strong vouching for the weaker ones,” he said, adding that he thought “a lot” of Macron’s call for the creation of a European finance minister role.
While it is important to recognise that the obstacles to the ultimate goal of a fiscal union remain immense, there are, at least for the time being, grounds for optimism. Markets have yet to grasp the significance of this. With the economy simultaneously picking up, recent developments could mark a sea change for equity markets that until recently were fixated on the risk posed by a series of European elections and the euro zone’s perennial economic problems.
Although European equities historically tend to trade at a discount to US peers, they look especially cheap in relative terms at present, notwithstanding their recent outperformance. Whereas the Eurostoxx index is trading on a multiple of 16.0x forecast 2017 earnings and 14.5x 2018 earnings, the S&P 500 trades on multiples of 18.4x and 16.5x respectively.5 That is despite the fact corporate profits are forecast to grow half as fast in the US as in Europe this year, and only slightly faster in 2018.6
The sluggish performance of European economies over the past decade or so has resulted in many companies reining in investment, particularly in new technology. Nowhere is this more apparent than in banking sector, where lenders have been struggling to shore up their balance sheets since the financial crisis.
With most banks having largely completed this task, we could start to see a big increase in IT spending. After years of underinvestment, we are starting to see lenders fighting back against ‘disruptive’ new entrants spawned by the ‘Fintech’ revolution. They are adapting their software to become more flexible and better able to address the new needs of their clients.
As ever, it is important to recognise there are various risks to the outlook. For a start, while the political situation in Europe may have improved in recent months, a number of important obstacles need to be overcome. Although Macron’s election may have raised the prospects for European reform, such an outcome is far from guaranteed.
Reforming the French economy will be painful and is likely to meet with stiff resistance from the country’s powerful unions. In any case, it is unclear Macron, with legislative elections scheduled for June, will be able to form a sufficiently stable government to push ahead with a reform programme in the face of certain opposition. Even if he does succeed, it is unclear how Germany will respond.
Other important challenges include an Italian election due to take place no later than May 2018. Recent opinion polls suggest the governing Democratic Party has slipped behind the anti-establishment Five Star Movement, which has floated the idea of exiting the euro. Beyond Europe, there is little sign of any easing of geopolitical tensions. As for the economic outlook, with speculation mounting that the European Central Bank may be on the verge of withdrawing the extraordinary monetary stimulus of recent years, it remains to be seen how European economies and financial markets fare in the face of tighter policy.
What is especially encouraging about the pick-up in corporate earnings is that it is starting to be driven by revenue growth as opposed to cost cuts. If that trend continues – and given the ongoing improvement in the economic numbers there are grounds for believing it will – that could transform the fortunes of Europe’s stock markets. There is reason to believe the recent pick-up in investment flows could be set to accelerate dramatically. After numerous false starts in recent years, it is starting to feel like this time could be different.
3 Source: Factset as at 30/05/2017
5,6 Source: Factset as at 30/05/2017
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