The case for increasing European investments is getting stronger, as we evaluate the fundamentals, valuations, and to a lesser extent the technicals. Throughout most of the region, we are seeing improvement in the economic data and most importantly, in corporate earnings. After a strong fourth quarter 2016 based on MSCI Europe earnings up 28%, earnings growth may be positive for the first time since 2013, albeit just barely, on a year-over-year basis. More importantly, earnings expectations for 2017 have been improving. Valuations for European stocks are relatively attractive based on forward-looking earnings estimates, though they still seem expensive based on trailing earnings. The technical picture, the last components in our investment process, is decidedly mixed. On an absolute basis, European equities appear to be close to breaking out. However, relative to U.S. stocks, European equities have stalled, at least temporarily. Much of the relative performance between U.S. and European equities will likely depend on currency markets, which in turn are likely to be largely driven by political actions in both regions.

I Love Paris (And Madrid And Rome) In The Springtime

In many parts of the country, we have not had much of a winter and are already several weeks into spring. Early season flowering trees and bushes are already in bloom; tulips cannot be far behind. Yet there is a sense of unease, that this is just too early and that a late frost could undo all the recent growth in one night. We have that same feeling about Europe. Sure, the economic fundamentals have been improving and corporate earnings are poised for their first increase since 2013.

Yet something still feels amiss. Europe has not solved many of the issues that have plagued it for almost a decade. The Greek debt crisis is still with us, though most agree it has been isolated such that a major default will not trigger a systemic crisis. Brexit?—?the U.K’s plan to leave the European Union?—?isn’t even official yet, with the two sides touting its probable impact as anything from a net positive for the U.K. to an economic apocalypse. As is nearly always the case, we suspect that the truth lies somewhere in the middle. Populism is now a major force in European politics, with three major elections this year (the Netherlands, France, and Germany), and a fourth (Italy) a possibility. The unknowns surrounding the outcomes of these events make it difficult for the markets, and LPL Research, to become too bullish on Europe just yet.

Fundamentals Are Blooming

We cannot repeat it often enough; ultimately it is corporate earnings that drive stock prices. European earnings, at least in U.S. dollar terms, had been in absolute decline for the past three years. However, strong results for corporate Europe for fourth quarter 2016 thus far (not all companies have reported earnings) are suggesting that the earnings growth drought may be over. After a strong fourth quarter, European earnings for the whole of 2016 are tracking to an increase of 1.3% over 2015, the first year of growth since 2013 [Figure 1]. Even more importantly, consensus earnings expectations for 2017 are not only strong at just over 16% growth, but have continued to rise as earnings reports come in and economic data are released in the first two months of 2017.

European Equities

European Equities

Overall, about 54% of European companies have had a positive earnings surprise, averaging 3.7% in the fourth quarter. Of course, growth is not uniform and there are always surprise winners and losers by country and sector. There has been an earnings turnaround in sectors typically considered highly economically cyclical, such as materials and energy. Materials companies’ earnings had a strong rebound in 2016, particularly in the fourth quarter. Energy sector earnings declined over the year, but like materials companies, posted earnings growth in the fourth quarter of 2016. However, both sectors have shown earnings disappointments; despite the growth experienced, global investors were expecting greater earnings gains for the year. Both sectors are expected to show significant earnings gains in 2017.

The financial sector is key for European equities. Financials, at about 20%, are the largest component of the major European indices. Furthermore, financials are the sector most likely to be directly impacted by the results of the Brexit negotiations, keeping in mind that the final decision on what the financial sector looks like post-Brexit is years away. However, the ability of U.K. banks to operate in the EU post-Brexit, a process referred to as “passporting,” is likely to be one of the most contested provisions of the final agreement, and one with a material impact on banks and bank earnings. Thus far fourth quarter 2016 earnings growth from the financial sector has been strong on an absolute level and relative to expectations.

When looking at valuations, Figure 2 shows that European stocks are cheaper than their U.S. peers based on calendar year 2017 estimates. However, emerging market equities still appear to us the most attractive both on an absolute and relative basis. We have examined a variety of forward indicators and they all yield approximately the same result. However, we have become more comfortable with using calendar year estimates, as they account for different regions having different seasonal affects.

European Equities

European Technicals Improve-But Still Trail U.S.

The STOXX Europe 600 Index represents large, mid, and small cap companies across 17 countries of the European region and is a great gauge for European equity markets. This key index has been in a steady uptrend since early 2009, finding support from this trend line once again in 2016 before a big bounce in December of last year [Figure 3].

European Equities

Notably, on a much longer-term basis, the 400 level on the STOXX Europe 600 acted as resistance in 2000, 2007, and again in 2015. This is an important level and should it give way to a breakout, it could finally usher in a period of potential European outperformance. The chart is currently forming what is called an “ascending triangle pattern.” As Figure 3 shows, this technical formation has a vertical top (the 400 level) and a lower ascending trend line (the green line). Should the price breakout to the upside, it would not only be a major bullish signal for European equities, but global risk assets as well. This still has a ways to go before it happens, but the possibility of a breakout is increasing.

European Equities

Here’s the catch: European equity markets are looking better in absolute terms, but on a relative basis they have lagged the U.S. markets since the late 1980s. There have been periods of European outperformance, but the overall trend has clearly been in favor of U.S. equities relative to European equities.

Think about it like this, the STOXX European 600 Index is still 8% away from the peak it hit in early 2000, whereas the S&P 500 is more than 50% above its early 2000 highs. Could this mean it is finally time for Europe to outperform the U.S.? There is no easy answer here, as one could have made that argument

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