European Equities – Yesterday’s Bears Become Today’s Bulls by Paul Doyle, Columbia Management
- We expect to see European earnings and economic growth expectations firming during the year.
- Even with the strong move in markets so far this year, European equity valuations are not unattractive in our view.
- The main risk (apart from tighter monetary policy in the U.S. and UK) is if energy prices recover and put upward pressure on European inflation.
The recent Merrill Lynch fund manager survey shows that 63% of respondents expect to be overweight Europe this year, up from only 18% a month ago, a record in the history of the survey. Despite this, equity markets in the periphery have been lagging those in core Europe by about 10% since the market lows last October. This is surprising given that the economies of the periphery should outgrow those of the core this year, while their equity markets are cheap and they remain the focus of the ECB’s efforts to head off deflation.
Some of the problems in the periphery are being fixed. Portugal, Spain, Ireland and Greece have seen unit labor costs decline by 10% since the start of the eurozone crisis while the rest of the euro area has seen costs inflate by 12%. This has effectively eliminated the competitiveness gap accumulated over the preceding decade. Wages in Greece are down 35% from their peak, and they are down 13% in Spain versus five years ago. Only Italy has failed to address this trend, but that is changing now following Mr. Renzi’s reforms.
The fall in the euro has helped the periphery’s external balances, and exports in the periphery have risen to 26% of gross domestic product (GDP) from 16% before the crisis. This is beginning to compare favorably with Germany which has effectively been no better than stable over the last few years. It has translated into a rising share of corporate profits as a percentage of GDP: for example, for Portugal and Spain, this figure is now 43% versus 39% for Germany and 34% for France. Large output gaps mean that there are no wage pressures.
The eurozone’s manufacturing PMI is above the expansion/contraction level of 50 and is now at a 10-month high. The euro price of oil is down 36% over the past year, despite the euro/dollar move. The eurozone current account surplus is now $270 billion compared to only $18 billion when we entered the eurozone crisis in 2011. While German government bond yields have fallen to new lows, eurozone economic surprises have been consistently positive all year. Pessimism towards the euro is at an extreme, and it could be susceptible to a recovery. Nonetheless, the medium-term trend for the euro is likely to be downward given that the U.S. economy, financial system and labor market are much further down the road from the crisis. A cheaper currency, on the back of QE, is the primary route that allows Europe to escape deflationary forces.
While European QE has come much later than elsewhere, it is happening at a time where central bank balance sheets in the U.S. and UK are likely to be shrinking. There is no accompanying asset sterilization program, nor any measures for specifically targeting certain needier parts of the economy, so the ‘pushing on a string’ argument remains valid. However, there is no doubt that QE has been a very positive catalyst for European equity market sentiment so far this year.
The impact of the weaker euro
Perhaps the biggest consequence of QE has been the continued weakening of the euro from a level above $1.21 at the start of the year to a low of $1.05 in the middle of March, a decline of more than 13%. While recently the level has risen a little, this still represents a fall of around 10% in Q1 2015. This move has favored dollar earners in the European market, notably aerospace stocks, auto original equipment manufacturers and auto supply stocks, and pharmaceutical stocks. Our portfolios have been overweight all of these sectors. It is worth noting that U.S. dollar investors have had their gains eroded by the currency weakness (unless hedged), so some stability in the currency may encourage further positive flows.
Exhibit 1: Euro vs dollar exchange rate
Source: Bloomberg, data to end March 2015.
Lower energy prices are an additional tailwind
Falling energy prices have several effects, notably boosting consumers in many large economic areas, reducing input prices for many companies and leading to significant reviews of long-term capital expenditure plans in many industries. Recent unrest in Yemen has led to a small rise in the oil price, but the long-term picture is very positive.
Fiscal drag is fading
This factor has been evident since the eurozone sovereign debt crisis first reared its head in 2010. Peak fiscal drag for the eurozone was more than 1.5% in 2012, which has since faded to zero in 2015 (Exhibit 2). Indeed, fiscal policy is forecast to provide a small boost in 2016. Borrowing costs are at rock bottom, and most European economies are now running primary surpluses.
Exhibit 2: Net fiscal position for the eurozone (% of GDP)
Source: UBS, data as at 12 March 2015.
Credit trends and bank lending are supportive
The latest bank lending numbers show that credit is now growing again in Europe and while deleveraging has not ended completely, it is no longer a drag on growth. Banks are being more accommodative towards lenders, and demand from both households and businesses is improving. The recently published results of the ECB’s TLTRO showed a higher-than-expected take up by the banks, which should lead to more credit and liquidity being made available. The flow of credit, severely lacking so far in this recovery, would be a strong signal that the eurozone economy is on an upward path to growth.
Capital flows and positioning
It is certain that much capital has flowed into European equities in Q1 2015, possibly as much as $40 billion (Exhibit 3). Our belief is that much of this flow has been fairly indiscriminate, typically using passive instruments. This presents a danger for markets, as we saw in 2014, if expectations for better growth and earnings are not ultimately met. We believe that it is extremely important to use active management to gain exposure to Europe.
Exhibit 3: U.S. flows into European equities have improved sharply
Source: AMG/ Lipper, US Treasury, Haver, Goldman Sachs Global Investment Research, as at 31 March 2015.
The road ahead for Europe
Looking forward, we expect to see earnings and economic growth expectations firming during the year. Many economic indicators are showing healthy signs, such as PMIs, retail sales and car sales. Meanwhile unemployment is falling and real wages are starting to rise. European earnings revisions have just turned positive, the first time since January 2011. According to Morgan Stanley, 95% of the rise in European equities since the market trough in March 2009 has been due to multiple expansion and only 5% has been due to earnings growth. So, if earnings really are moving up, there is plenty of room for progress. Earnings expectations for 2015 started the year at 8% and now stand at 9%. We are currently assuming 10% corporate earnings growth for Europe ex UK this year. Similarly, the consensus GDP forecast for the eurozone has been upgraded from 1.0% to 1.3%. While there is little room for disappointment, this could be the first year of upgrades since 2010. Encouragingly, deflation fears appear to have peaked, and we are starting to see signs of structural reforms in two of the laggard countries in the eurozone, Italy and France. Current credit growth, if annualized, would produce a €120 billion (1.2%) boost to eurozone GDP. Such is the level of operational gearing in European corporates that this could take our earnings growth numbers up to 15-20%.
While the strong move in markets so far this year suggests a lot has already been discounted, European equity valuations are not unattractive, particularly compared to fixed income and cash. The European market is still yielding more than 3%, compared with zero or negative rates in many other instruments. Additionally, should we start to see nominal growth rates improve in the domestic economies of Europe, there will be further operating leverage which should drive European profits much higher in the next few years, against a backdrop of static or falling earnings in many other regions of the world.
The ECB has committed to €1.1 trillion of QE, at least until September 2016. The main risk (apart from policy tightening in the U.S. and UK) is if energy prices recover and put upward pressure on European inflation. This would begin to remove the justification for QE in Europe and so raise the spectre of tightening in Europe. That would cause a severe rise in European bond yields and a fall in equity prices but such an outcome does not look likely any time soon.