Olly Russ

Are the stars aligning for European equities?

Olly Russ

Around this time last year I was sitting down to write a fairly lengthy assessment of the likely market reaction to the looming Italian referendum, which I later published in an imaginatively titled blog: “How will markets react to the Italian referendum result?”.

This choice of topic reflected the mood at the time. Hindsight has shown the referendum result – a resounding defeat for then-prime minister Matteo Renzi, which cost him his job – to have had little adverse impact on the European economic or political scene so far. But a year ago UK investors were looking ahead to a busy European electoral calendar with the shock Brexit vote fresh in their memories. Populist parties in France, Holland and Germany were all seen as likely winners from the Brexit effect. The Italian referendum marked the start of what was seen as a potentially tumultuous 12 months in Europe.

The prospect of political turmoil was understandably causing significant investor nervousness, although in our view the most feared outcomes never stood much of a chance of materialising in reality. This nervousness was most probably leading investors to apply a risk discount to their assessment of European shares’ fair value.

This discount has unwound somewhat in 2017, with the MSCI Europe ex-UK Index returning 16.3% in sterling terms so far (12.9% in local terms)*, although arguably this is actually just in line with predicted earnings growth this year. Investor sentiment has improved noticeably though since the electoral victory of French President Macron in May.

UK investors now appear to be sitting up and taking notice. Investment Association data for September shows a net £489m being injected into Europe ex-UK funds – the 3rd most popular sector out of 37 – up from -£183m in the same month a year previously when it was the 3rd most out-of-favour area. Despite this recent popularity, over the last 20 months there still have been essentially no net flows into European equity exchange-traded funds (ETFs) according to UBS a period during which US equity ETFs have seen a US$322bn inflow.

In our view, the recent improvement in the outlook for investing in Europe results from the alignment of three key elements:

  1. A more stable political outlook. The Catalonian bid for independence is the most newsworthy geopolitical European event at the moment. We should not underestimate its importance to the parties involved, but it is not an event that will trigger a eurozone breakup, or have any real impact outside of Spain. This is much less alarming than the horrors posited at the start of the year. Indeed, if anywhere has taken on the mantle of European political instability at the moment, we would probably have to point to the UK.

  2. A booming economy. The titles of my last two blog updates in recent months – “The return of confidence in Europe” and “Banking on European growth”– suggest that we’ve been aware of improving macro fundamentals for a while. The stats increasingly back this up. GDP forecasts have been consistently upgraded all year. The International Monetary Fund (albeit not always noted for its excellence in forecasting) recently upgraded its euro area growth forecast for 2017 and 2018 (by 40ppt and 30ppt vs April 2017’s forecasts to 2.1% and 1.9% respectively) while downgrading the UK 2017 forecast to 1.7% (-30ppt) and forecasting only 1.5% in 2018. Even now European GDP expectations are probably lagging reality in our view. We think 2017 GDP growth could eventually turn in at about 2.5% after revisions while in 2018, barring unexpected events, we could see another 2%+ year.

  3. A benign environment for corporate earnings. Political stability and accelerating economic growth look to be filtering down to the corporate level. Take the recent Q3 earnings season as a case in point: Barclays’ analysis suggests that with 77% of its European universe having reported Q3 results, the median company beat analysts’ consensus earnings per share estimates by 140bps. Admittedly, some of this differential can be accounted for by expectations being set at achievable levels, but it does suggest that the very positive macro backdrop is feeding through to a benign corporate environment. It is worth remembering just how far European corporate earnings (and therefore markets) have lagged behind those of their American cousins. Even now, nearly 10 years on from the Global Financial Crisis (GFC), European earnings (and markets) have yet to exceed prior peaks. This is because Europe managed to tack on a second major crisis – the eurozone crisis – almost immediately after the GFC.

In the investment process we apply to the Liontrust European Income and Liontrust European Enhanced Income funds we obviously focus more on cash dividends than mere accounting earnings. However, in the long term, earnings growth should lead to greater profits being available for distribution to shareholders, and therefore rising dividends too.

European stars therefore appear to be in somewhat of a rare alignment currently: politics, economics and earnings all seem to be developing in a favourable way simultaneously. Potentially, this means not only that earnings numbers can expand, but the multiple paid for those earnings could expand too. Be that as it may, as we now look forward to 2018, we see another solid year of earnings growth (consensus currently stands at c.9.2%). It would seem that the earnings dynamic in Europe has finally changed.

*Source: FE, 31/12/16 – 15/11/17


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Thursday, November 16, 2017, 11:31 AM