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Olly Russ: It’s the economy (not politics)

Posted in [Fund Managers' Blog] By Olly Russ
It’s the economy (not politics)

Today’s Dutch election result saw the incumbent centre-right VVD party beat populist anti-immigration candidate Geert Wilder’s eurosceptic PVV party. Will this mark a turning point in the growth of populism and the associated undercurrent of anti-euro feeling? And what impact does the political outlook have on the European companies we invest in? 

It seems that many investors appreciate that the economic outlook for Europe is improving, but have so far been put off by the political backdrop, which admittedly looks dire. By year end, however, I expect the populist insurgencies so feared in the Netherlands and France to have come nowhere close to government. Meanwhile, increasing confidence in the European economy should help corporate earnings begin to catch up those of elsewhere, a move which is long overdue.

Indeed, parts of the eurozone economy have stagnated for over a decade – with companies’ average earnings per share still no greater than they were 10 years ago. However, we believe that European corporate earnings are not dead, but sleeping – and 2017 might be the year they finally wake. In this respect, yesterday’s US rate hike should be far more significant than political events.

The growth of populist parties such as Wilder’s PVV (which, with 95% of votes counted, has gained five seats to hold 20 out of 150, the second largest party) has led to predictions of the unravelling of the European monetary union, undermined by nationalist sentiment and sub-par economic growth, but we would characterise this narrative as essentially ‘noise’ – albeit noise that is only likely to grow in volume given this year’s European electoral timetable.

The reality is that the populist parties of the eurozone will remain some distance from the levers of actual power, having little effect on the governments of their various nations, let alone the earnings of the companies in which we are invested. Other Dutch parties (and there are 28 in all!) have said they will not work with Wilder, so he cannot form part of an administration, nor can he easily apply his political capital to bring about ‘Nexit’, given that a constitutional change would be required for any referendum on the subject to be binding. This would require a supermajority which would be entirely impossible for the PVV to assemble. The Dutch are, in any case, one of the less Eurosceptic nations of the EU.

Investors who are concerned with the fundamental outlook for European companies would do well to look past the headlines around this year’s European elections and instead consider the other key market event yesterday: the US Federal Reserve’s rate hike.

This is the third hike in the Fed’s current tightening cycle which began in December 2015. Additional hikes were probably derailed by the US election campaign, but now that there is some consensus forming around a Trumpflation trade, we have seen rate expectations pick up markedly. The chart below shows the rapid rise in expectations of a hike to a 0.75% - 1.0% range according to futures markets ahead of yesterday’s FOMC meeting. This is shown by the blue line, which represents a hike, tending towards 100% probability (from around 30% at the start of the year).


Bloomberg chart


Markets are now pricing in a further three 25bp increases in 2017. As rate expectations have risen, so too have long-term US bond yields: the 10 year treasury now yields 2.4%, up 0.8% since 30 September 2016. Rising long-term US yields tend to correlate with better relative performance of European equities, driven by ‘value’ areas to which Europe is biased, in particular the financials sector, where higher rates mean better net interest margins for banks and better reinvestment rates for insurers. Since we expect US bond yields to continue to rise, we have built into the Funds a substantial overweight position in financials.

An inflexion in European equities relative to their US counterparts is certainly overdue. The average earnings of European and US companies were on the same trajectory ahead of the Great Financial Crisis (GFC) in 2008/2009. They have since diverged: while Europe’s are still a third below their peak as the region stumbled from the GFC straight into the eurozone crisis, the US has soared to new highs, albeit with some help from accounting sleight of hand. 

Europe v US: average earnings per share

Europe v US: average earnings per share
Source: JP Morgan, as at December 2016.

This differential in earnings growth is, however, more than adequately reflected in the discount at which Europe’s shares now trade (measured by the cyclically adjusted price/earnings) when compared with the US. This means that there could be value for those that believe there will be a narrowing of the differential in either earnings or valuations.

Europe cycle-adjusted PE versus US
Europe cycle-adjusted PE versus US

A narrowing may now indeed be justified. We could be approaching an earnings inflexion point, underpinned by better economic data, which is very unlikely to be undermined by political events.  Earnings have gathered momentum, the economic surprise index is trending upwards and analysts’ revisions to forecast earnings – locked in a serial downgrade cycle in recent years – finally look to have bottomed out.

At the macro level, European unemployment is falling and bank loan origination is growing.  Both come from weak starting points, but are heading in the right direction. In addition, it must always be remembered that not all members of the eurozone are created equal: Germany for example currently enjoys record low unemployment. Nor is the eurozone the whole story of Europe – Sweden stands outside the single currency and is enjoying something of a mini-boom.

We do not of course advocate disregarding the European political landscape entirely (which this year will also include German elections and possibly an early Italian election). For example, a Le Pen victory in France would represent the greatest risk of a populist political result contaminating Europe’s economic outlook, due to the disastrous consequences of the economic policies she plans to apply.

We expect Le Pen to win the first round of voting, but to then lose the second round to either conservative Francois Fillon or centrist Emmanuel Macron. Although her chances have risen following M. Fillon’s attempts to blow up his own campaign by allegedly making payments to family members for fictitious parliamentary work, they are still priced at around only a 30% probability. Even a victorious President Le Pen would find it difficult to implement much of her programme given her virtually non-existent current power base in the Assembly.

Oddschecker.com implied probability of Le Pen win

Oddschecker.com implied probability of Le Pen win

Source: Bloomberg, Oddschecker


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