Money moves into European equities as region steps back from the brink

The European Central Bank (ECB) is predicting the continent’s economies will shrink by 0.3 per cent this year but with a wide range of performances from over 1 per cent in core Europe to below -1 per cent for the peripheries. 

Most economists see it as a healing process, and say the eurozone crisis will not be over until monetary policy transmission mechanisms are fully functioning.

The 20-30 per cent rally in the second half of last year was largely driven by ECB president Mario Draghi’s comments, which calmed the fear of break-up, a risk so great that it was hard to put a price on it. But real fundamental improvement is harder to identify, though there are some signs in earnings revisions and improved financing costs in the South.

Where there is general agreement is that the market is cheap because economic growth projections are mediocre, and valuations are still not extended on a historical basis. Many popular stocks such as Nestlé, Unilever and LVMH are trading on P/E ratios of around 18 but have previously touched levels as high as 30-40.

“The region is cheap on a valuation basis, compared for example with emerging markets and the US, particularly if you use price to cashflow which is a raw and more meaningful metric and less influenced by accounting policies than P/E ratios,” says Philippe Brugere-Trelat, portfolio manager with the Mutual Series team at Franklin Templeton Investments. “The Euro Stoxx is trading on 7.5X, while the S&P is on 9.9X.”

What is more unusual historically is for corporate dividend yields in Europe, currently at 3.8 per cent, to be higher than Treasuries. They also compare well with dividend yields  of 2.3 per cent in the US.

So weak are opportunities elsewhere that Europe is attracting strong investor interest, and although European equity funds suffered net outflows of €6.8bn in 2012, the reversal in the fourth quarter produced inflows of €13.7bn from October to December and €7bn in December, according to Morningstar data.

Many wealth managers recommend slight overweights to the region. “There are two prime reasons we prefer this sector over emerging markets,” says Joost van Leenders, investment specialist, allocation and strategy at BNP Paribas. “First, valuations are lower in Europe than in the US or Japan, and secondly, the impact of currencies and the likelihood the euro will depreciate over time, which will have a positive translation effect of foreign profits and make it easier for eurozone companies to compete in the global market.”

But there are still major obstacles to national competitiveness within a common currency block in the shape of disparities in productivity and wage costs. Above inflation wage settlements in the public sector in Germany for example, have been gradually exacerbating its loss of competitiveness. 

It is the south that may produce surprises on the upside. In some peripheral markets, productivity has improved, wages have declined, and foreign direct investment is returning. IT companies are switching capacity out of India into Spanish cities and car manufacturers are increasing production. There is a lot of talk about 50 per cent unemployment rates among the under-25s in Greece and Spain but these figures mask a healthy black market and take no account of young people in further education.

Jeff Taylor, Invesco Perpetual’s head of European equities, thinks the ECB forecasts may be pessimistic, and believes there is a chance of positive surprises from the periphery. Economists have generally been too pessimistic, particularly about Spain where the consensus prediction for the year is negative growth of  -1.5 per cent, so there is every possibility they have made the same forecasting errors this year, he believes.

That said, some industries have abandoned the region. Nicolas Walewski, fund manager at Alken, remains concerned about the rising cost of energy due to the increase of renewables in the production mix. “Many industries are leaving Europe for Asia or the US because of the cost of energy and won’t be back any time soon, and this negative effect is far from over,” he says.

Italian elections

The Italian elections were an eye opener. Mr Walewski points out that we have rarely seen an Italian prime minister in the post for more than six months since 1945. “Does it change anything? Not likely,” he says. “The Greek elections were probably worse and it didn’t matter after all. The Italians are used to this political instability, but I believe the Italian political classes remain committed to Europe.”

But others are slightly incredulous. “How can a comedian get 25 per cent of the vote? It highlights the level of anti-austerity and anti-establishment feeling from the public,” says James Butterfill, equity strategist at Coutts Wealth Management, who will be looking to add if the market tips below 2500.

In comparison, financial markets should take the Germany elections in their stride as they are  likely to result in either a continuation of the current conservative-led coalition, or a grand coalition of conservatives and socialists which would be pro-European.

Mr Draghi’s comments last summer were a profound turning point, removing the risk of an implosion in Europe. “The best proof is that without the ECB spending a penny, the spreads of sovereigns Italian and Spanish bonds fell massively, and the risk premium attached to investing in European equities fell as well,” says Mr Brugere-Trelat at Franklin Templeton. 

“Now, if we look back at the rally in European stocks since last summer, it was driven more than anything else by relief. It is fair to say that the easy money has been made. For it to continue, we need more clarity on corporate earnings,  which, so far, have proven to be quite good but not great.”

One encouraging factor is that more than one quarter of European GDP is derived from exports, says Mr Brugere-Trelat. “Europe is the most open economy in the world, and what we have heard from companies we meet is that business is better in Asia and the Americas than on the home front,” he says.

“What would make me very optimistic is if growth measures were to be implemented across Europe alongside austerity measures, such as labour market reforms. It has become clear that austerity alone is not the solution to Europe’s problems. You need to see a resumption of growth, without which tax revenues won’t grow and fiscal deficits will endure.”

The recent Italian elections demonstrated this need for growth measures, while the French elections a year ago were the first sign of that, says Mr Brugere-Trelat. “Looking at Italy and Spain, the austerity programs enacted a couple of years ago are starting to bear fruit. Italy’s primary budget is in surplus, and its official budget deficit for this year is only 1 per cent of its GDP which is good compared with France, the UK, Japan or the US. Spain is now running a trade surplus with the rest of the world, a small but positive step in the right direction.”

If tensions around the eurozone continue to wane, there will be fewer reasons to be cautious  and  the safety premium attached to some European mega cap stocks could decline, but by and large wealth managers are happy to retain selective positions in these stocks. 

“The market is still vulnerable to macro economic factors, which move in and out of focus, but are always there,” says Frederique Carrier, head of European equities at RBC Wealth Management.

“We look for companies with a high percentage of international sales – 50 per cent of revenues from outside of Europe, preferring those with a competitive advantage in niche markets or in an industry with a high barrier to entry and high recurring revenues with high margins. Many companies in consumer staples, consumer discretionary or industrials have these attributes. These stocks are now on P/E ratios of around 18 but even though some are trading at a premium, they could get to much higher levels.”

She cites lift maker Schindler which has a cyclical aspect to its business but  makes greater margins on lift maintenance revenues.

Banking woes

Traditional banking business is out of favour.  Jeff Taylor, Invesco Perpetual’s head of European equities, likes financial names such as Bankinter in Spain, Allianz, AXA, Ageas in Belgium, and ING, but only those with strong insurance arms.  Mr Butterfill at Coutts is suspicious of the rally in European banks, believing the current loan write down ratios of 3.5 per cent suggests they are burying their heads in sand as typically 10 per cent of loans are written off.

Low cost operators also appeal in this market, such as low cost solutions in telecoms, and airlines such as Ryanair, a much cited example, which thrive in an environment where the European consumer is under pressure, says Fabio Di Giansante, senior portfolio manager at Pioneer Funds’ Euroland Equity fund, which holds a group of companies they call ‘Right Business Model’ companies.

“These are companies with high exposure to Europe, which have the ability to continue to grow market share and generate revenues through the strength of their business model and competitive positioning. Examples include Ryanair which is 100 per cent exposed to Europe. Inditex (Zara) is another example. It continues to grow strongly despite high exposure to the periphery through its business model, which utilises proximity sourcing and now an online offering.”

The challenges of the last few years have it seems produced some wonderfully lean and dynamic companies.  As Jeremy Whitely, head of UK and European equities at Aberdeen, notes: “It is no bad thing  for companies to be put under pressure to keep them honest and at the forefront of improving themselves.”