Do European Stocks Have Room to Run?
The European economy is improving on multiple fronts.
Emmanuel Macron has been elected the next president of France, eliminating a major risk and inserting some near-term certainty into the markets. Following Macron’s advancement in the first-round election on April 23, European equities rallied strongly. Given his outright victory, many investors are wondering whether or not European assets have more room to run. I believe the short answer is, “Yes.” In this month’s commentary, I’ll briefly explain the reasons why.
Political and economic dynamics, as well as asset valuations, all support the case for continued attractive performance from European equities. First, Macron’s victory minimizes the risk of a eurozone breakup. Second, the European economy is accelerating at least as fast as the US. Third, European equity valuations, while no longer cheap on an absolute basis, are attractive relative to US valuations.
Politics: A huge reduction in risk
The threat of a eurozone breakup has been hanging over markets since 2010, when Greece’s indebtedness threatened the collapse of its economy and its exit from the EU. Since then, doubts about the eurozone’s cohesion have resurfaced every year, most notably with 2016’s UK “Brexit” referendum.
Macron’s victory puts talk of disintegration to rest. Macron, a political outsider, is free-market, pro-business, and pro-euro oriented. Although he is sure to face opposition for cutting public spending and reforming the labor market, his plans are relatively modest and many are realistic in terms of implementation. Finally, Macron backs free trade and is expected to partner with Germany to strengthen the eurozone.
Italy still presents political risk. The Italian economy is weak, the electorate is more anti-euro than the French, and the anti-establishment Five Star Movement is ahead in the polls. Still, even though Italy is the third-largest economy in Europe, I don’t think the impact of its presidential election will be top of mind for investors until the vote nears, which may be during the first quarter in 2018 at the earliest.
German elections are in September, but the odds are extremely high that the centrist party line will continue regardless of any coalition that is formed. Finally, the Brexit negotiation will be long and noisy, but it will ultimately be more damaging to the UK’s economy and markets than Europe’s.
Economy: Europe is on the rise
The European economy is improving on multiple fronts, with leading indicators consistent with 2.5% to 3% gross domestic product (GDP)1 growth. Owing in part to an improving employment picture (9.5% in March compared to over 12% four years ago), eurozone consumer confidence has improved to pre-global financial crisis highs, helping to lift retail sales. The recent spike in the Purchasing Managers Index2 (Figure 1) implies strong industrial production growth. This is an important leading indicator of capital spending plans and the overall economy. Another favorable input for Europe is emerging market (EM) stability, which is supporting European exports and boosting EM-generated revenues, which accounts for 30% of Europe’s total revenues. These positive economic factors should also lift the euro.
Sources: Haver Analytics, Markit
Valuations: No longer cheap, but attractive relative to the US
It’s no secret that European equities have disappointed, delivering a quarter of US equity returns over the past 10 years in local currency terms, and even less in US dollar terms. Figure 2 shows that Europe is now cheaper on a price-to-earnings (PE)3 basis than the US over the short and long term but is expensive relative to Japan. European equities have historically traded at a discount to US equities but that discount is also larger than normal over multiple time periods.
European equity valuations are attractive (as of 4/30/17)
Sources: Datastream, IBES, Wellington Management
In addition to political turmoil, poor equity performance can also be attributed to years of stagnating earnings in the region. Today, earnings look set to recover. Figure 3 shows the ratio of stocks with increasing earnings-per-share estimates versus decreasing estimates. When the ratio is above 1, it indicates that positive earnings revisions are outpacing negative ones. The massive recent improvement in Europe sends a strong signal, in my view, that earnings can continue to improve, making current P/E valuations look even more attractive.
Positive earnings revisions outpacing the US
Ratio based on rolling 3-month periods
Past performance is not a guarantee of future results. Indices are unmanaged and not available for direct investment.
Source: Datastream, IBES, Wellington Management
Risks to these views
In addition to the various political risks, questions about the actions of the European Central Bank (ECB), including its trajectory of monetary tightening, remain a factor. I think that tightening may continue, but the magnitude and timing of those moves should be quite moderate. Specifically, I expect the ECB to gradually reduce asset purchases, starting early next year. Importantly, a hike in the ECB’s deposit rate would likely occur only after the purchases are wound down.
Consider adding to European equities unhedged — The tug-of-war between risky politics and improved economic fundamentals has largely resolved in favor of economic fundamentals. In addition, European asset valuations remain attractive, especially compared with the US. Given the 25% fall in the euro over the past few years, international investors may want to consider adding to their European equity exposure unhedged.
Look to sectors and market segments that are most sensitive to an improving European economy — Focus on cyclical industries including financials, consumer discretionary, and industrials. Small-, mid-cap, and value-oriented companies are also likely to be more sensitive to accelerating economic growth.
Domestic companies stand to benefit most from Europe’s recovery — Companies that derive most or all of their revenues from customers in Europe are less exposed to fundamental risks outside the continent which is important given that more than half of the revenues in European markets are generated outside of the continent.
European financials are attractively valued — Banks, insurers, and asset managers are well positioned to participate in the recovery, especially if core bond yields rise, which I think is likely.
Avoid UK equities — The broad European indexes include the UK, but I suggest avoiding the UK, especially in consumer-related sectors in which higher inflation from a weak currency is likely to weigh on consumer spending.
About the Author:
Nanette Abuhoff Jacobson is managing director and multi-asset strategist at Wellington Management Company LLP and global investment strategist for Hartford Funds.
With more than 25 years of experience in the capital markets, Nanette has held a variety of roles spanning the major asset classes. As the global investment strategist, she analyzes and interprets markets and investment opportunities for those mutual funds that are sub-advised by Wellington Management Company LLP, and shares those views with Hartford Funds’ sales organization, the financial advisor community, and major broker-dealers and distributors. She also advises Wellington Management's institutional clients, including pension funds, insurance companies, endowments and foundations, and central banks, consulting on strategic asset allocation issues to develop multi-asset investment solutions.
1 Gross domestic product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
2 Purchasing managers’ index is an indicator of the health of the economy. Readings over 50 suggest economic growth should rise from its current pace, while readings under 50 suggest economic growth should fall from its current pace.
3 Price/Earnings is the ratio of a stock’s price to its earnings per share.
4 MSCI Europe Index is a free-float adjusted market-capitalization-weighted index designed to measure the equity market performance of the developed markets in Europe: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.
5 S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.
All investments are subject to risk, including the possible loss of principal. Foreign investments can be riskier and more volatile than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as political and economic developments in foreign countries and regions (e.g. “Brexit”). These risks are generally greater for investments in emerging markets. Small- and mid-cap securities can have greater risk and volatility than large-cap securities. Investments in particular sectors may increase its volatility and risk of loss if there are adverse economic consequences in those sectors. Fixed Income risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall; these risks are currently heightened due to the historically low interest rate environment.
The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.