GMO International Active Update First Quarter 2015

REGIONAL COMMENTARY

On the global menu of asset classes, European equities are the flavor du jour. A more generous QE package from the ECB than discounted by the markets coupled with tentative signs of economic improvement in the eurozone have been enough to send the MSCI Europe index 11.6% higher in local terms in the first quarter. In contrast, the S&P 500 is only marginally above where it began the year.

The bullish case on European equities centers on cyclical recovery potential in the eurozone with earnings in the region still 30% below their 2007 peak, while other areas of the world have recovered, for example, U.S. aggregate earnings are 25% higher than 2007. Given that EU equities remain cheaper than their U.S. counterparts (at least on measures less prone to cyclicality, such as price to book and cyclically adjusted P/ Es), the case for buying Europe seems compelling.

While not denying the relative appeal of European equities over the U.S., the argument that European equities represent an attractive investment on absolute grounds is far less strong. In 2012, trough valuations on (hopefully) trough earnings in the eurozone were commonplace. This is not the case today. Draghi’s reassurance on the durability of the faltering eurozone saw risk premiums diminish and powered a strong rally in 2013. Unfortunately, the eurozone then failed to deliver on the earnings upside the bulls envisaged. The economic outlook remained poor and earnings momentum weak. Hence, the disappointments of 2014.

There are better hopes on the macro front today. Whether QE can boost economic growth remains a question, but there is little doubt that it can weaken currencies and hence boost a country – or a region’s

– export sector. Thanks in part to euro weakness Mario Draghi has been able, without facing derision, to raise growth forecasts for the eurozone to 1.5% for 2015 and to 1.9% for 2016. This has been the first material upward revision in the one-year forward GDP forecast by the ECB since 2011. And, the market needs earnings to improve to generate upside. Since March 2009, 94% of the rise in eurozone equities can be attributed to multiple expansion, meaning only 6% can be accounted for by earnings growth.

There are also reasons for caution. The case for demand in many European industries being structurally, rather than cyclically, weak remains potent. Autos are a prime example. Western European auto sales peaked in 1999 at 15.1m units. In 2014 they were 12.1m units, up from the 11.6m trough in 2013. Certainly this suggests some cyclical recovery potential (though far less than in the U.S. market, where sales plummeted 50% in 2008). But, it could be argued equally that it bears similarities to the Japanese market, where sales have been falling for 20 years as factors such as poor demographics take their toll. It is notable that auto sales in Europe now are only 1.5m units (11%) below their 25-year average. It seems unclear where a V-shaped recovery will come from. The European working age population is declining, and on a country basis, only Spain and Italy appear to offer meaningful recovery potential compared to long-term trends (auto sales in both countries are close to 30% below their 25-year averages; in contrast France is only 10% below its long-term average and Germany 5%). Yet, unemployment and, importantly, youth unemployment, remains stubbornly high in both Spain and Italy. Perhaps Draghi’s QE package will end this malaise, but given this backdrop it seems very optimistic to expect a major Europe-wide rebound in auto sales in the short term. Even if such a rebound does materialize, it is worth noting that among the car makers only Peugeot really offers significant gearing to European markets. Most other European car makers have diversified away from dependence on Europe into emerging markets, where growth is slowing.

Autos are not alone in failing to offer significant cyclical recovery potential. Utilities look to have structurally impaired earnings compared to their 2007 levels thanks to the huge growth in renewables. Elsewhere, European banks look highly unlikely to see strong improvements in their returns on equity, thanks to higher capital ratio requirements and less tolerance for leverage within the sector.

 

Finally, the lumbering edifice of the European state and the straitjacket of the euro remain burdensome. Despite these problems, the market seems to have swung from extreme skepticism regarding the durability of the euro project to unjustified optimism in its resilience. The euro remains a remarkable test bed in the acceptance of democratic states of economic adjustments via deflation rather than letting a country’s currency take the strain. The benefits of low oil and a depressed euro – though undeniably potent in the short term – could prove ephemeral.

In a world of assets offering low returns, European equities undeniably look to be a less bad place to invest. Some European sectors – building materials, for example – do appear to offer notable cyclical recovery potential. But, these are more the exception than the norm. Those who argue for blanket cyclical upside throughout Europe are likely to be disappointed.

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