European equities worth exploring

Few things mark so clearly how wealth managers’ attitude to Europe has changed than the fact that some now see political turbulence as a spur to enter rather than exit eurozone stockmarkets.

“We think Podemos has given us a potential buying opportunity in Spain,” says Jeffrey Sacks, capital markets strategist at Citi Private Bank in London. The ascent of Podemos, a new left-wing anti-austerity party, has at times frightened financial markets. However, he believes many important reforms which are likely to accelerate economic growth in Spain, and hence corporate earnings, have already been implemented and are unlikely to be rescinded completely even if Podemos wins power. 

This new-found optimism about the eurozone is founded partly on a sense that its political and financial system is now on much firmer ground, following tough action taken by the European Central Bank and reforming governments. It also rests on a conviction that the eurozone economy is in a much better state, and eurozone companies are likely to see strong earnings growth. Much of this can be credited to the recent fall in the euro, which dropped by 24 percent from a May peak of $1.40 to $1.07 – boosting corporate earnings. As a result, many wealth managers are eager to beef up clients’ exposures to eurozone equities. 

A 10 per cent decline in the value of the euro should add about 5 per cent to eurozone corporate earnings, because listed eurozone companies export so much outside the currency union, calculates Themis Themistocleous, head of the European Chief Investment Office at UBS Wealth Management in London. 

The fall in the value of the euro should add 9 per cent to earnings this year, according to his estimates. Its drop contributes more than any other factor to his estimate of 15 per cent earnings growth this year for eurozone companies, excluding the energy sector. If achieved, this would be the highest rate since 2010. The rest should be made up of a combination of higher growth in turnover – boosted by the bloc’s acceleration in GDP growth – and higher margins on this top line growth. This is because spare capacity in corporate Europe should enable turnover growth to be taken as profit. “Fifteen per cent is not that demanding when you consider these factors,” he concludes. 

Responding to this, UBS is overweight eurozone equities in tactical asset allocation, which guides investment positions over the next six months. It sees particular promise in small and mid-sized industrial companies, set to benefit from recovery of the domestic economies on which they are focused. They have not been bid up as much as larger export-focused companies.  The forward price-earnings (p-e) ratio for the European Mid-Cap MSCI is, at 17.9, at a premium of only 10 per cent to the MSCI EMU, he says, compared with an average over the past seven years of 23 per cent. 

Citi Private Bank has a similarly bullish view of eurozone equities. One reason for this is belief that corporate profits will reach double digits because of the recovery of the eurozone economy. “What is important is the rate of change. In 2013 growth was negative, and last year it was low. This year it will approach 1.9 per cent,” says Citi’s Mr Sacks, adding that strong dividend growth, as companies pass on increased profit to shareholders, will boost equities. 

“At this stage the rally is broad,” he says. However, “in the second half of the year, we think there will be greater divergence”. Consumption stocks are likely to be the winners of greater divergence because they will benefit from lower oil prices, says Mr Sacks. 

Eurozone banks could also benefit from signs of a pickup in lending, according to Citi. “We’ve focused on quality banks trading just above book value, with returns on equity improving quite quickly,” says Mr Sacks. “The leading banks in Northern European countries are where we’re focused.” 

His rationale: “We’re moving towards the second stage of the bank story. The first stage was led by recovery from distressed situations after recapitalisations, but now leading banks are likely to be driven forward by genuine growth in earnings, driven by rising loan growth and fee income.”

On a country level, Citi likes Spain – “a recovery story: the economy and stocks have further to go” – and Germany, because its exporters will gain from the weak euro. 

ABN Amro Private Bank went overweight eurozone equities back in 2013, and remains so despite, as Didier Duret, chief investment officer in Amsterdam, points out, a sharp narrowing of the valuation gaps between US and eurozone equities. 

The MSCI Europe index was, at 17.3 times forward earnings in mid-April, below the MSCI US index’s forward price-earnings ratio of 18.2. He agrees with the consensus that a weak euro is good for eurozone equities, but argues investors have already priced in much of this benefit – producing a “massive rally” so far in eurozone stocks. Looking forward, “the market will only be driven higher by an earnings surprise,” which would push down the forward p-e ratio. In other words, the market has been pushed upwards by expectations, but now needs concrete results. 

But many companies could report higher earnings than the often conservative forecasts that feed into forward p-e estimates for eurozone markets. “The export sector is where earnings surprises can be expected, because of the effect of lower oil prices on their margins, and of higher exports on their volumes,” says Mr Duret. As a result, “we still expect eurozone equities to outperform in the months ahead”.

Some wealth managers think conventional ways of measuring whether eurozone equities are good value are inadequate. “The undervaluation of eurozone equities has clearly been corrected,” says Christophe Donay, head of asset allocation at Pictet Wealth Management in Geneva. “There’s no value any more in absolute terms, or relative to other equity markets such as the US.” 

After adjusting for sectoral difference between markets, he calculates the Stoxx Europe 600 index, which includes both eurozone and non-eurozone countries, is more expensive than the US on a forward p-e basis. However, “liquidity” – unleashed by ECB policy, including current quantitative easing – “is the fundamental driver of eurozone financial markets. The rise in the equity market is an expression of liquidity and nothing else.” He expects eurozone equities to keep rising as liquidity continues to be pumped in. Pictet went overweight eurozone stocks at the beginning of the year.

FIXED INCOME’S FAILINGS

Wealth managers’ enthusiasm for eurozone assets is not entirely limited to equities, but largely so. Ultra-easy ECB monetary policy, and expectation that this will continue, has pushed rates down to unappetising levels. “Given the very low yield environment, bonds are currently not the most fascinating investments,” says Anja Hochberg, chief investment officer for Switzerland and Europe at Credit Suisse in Zurich. 

“We especially dislike core government bonds, and recommend investors focus more on high-yield.” Some single-B issues, such as Wind Telecomunicazioni, the Italian mobile operator, are yielding more than 5 per cent. By contrast with bonds, Credit Suisse recommended a tactical overweight in eurozone stocks back in January. 

A strategy that emphasises equities and high-yield bonds, and underweights core sovereigns, signifies a large amount of optimism about the political future of the eurozone. Ms Hochberg insists that she remains watchful: “Being worried, looking for the risk, is part of your job description.” She sees a 20 per cent chance that Greece will exit the eurozone, while believing it most likely Greece and the EU will find a compromise over their debt negotiations, enabling Greece to stay in.  

Even if Greece does exit, “it might not be as harmful for financial markets as it used to be. The danger of financial contagion from Greece has significantly reduced in the last couple of years.” Credit Suisse and other wealth managers cite the low amount of debt now held by eurozone commercial banks, rather than by public institutions including the ECB. 

Like Citi, Credit Suisse sees political turbulence as a chance to buy. “In the medium term I would see a Greek exit as an entry opportunity,” says Ms Hochberg, noting this might temporarily send eurozone stockmarkets surging by up to 10 per cent. 

Wealth managers’ sense of ease about eurozone political ructions is based largely, at heart, on a sense that however radical individual parties might seem, there is a broad acceptance of the need for reforms that will liberalise labour and product markets, with the aim of boosting economic growth. The example of France is cited by David Kohl, chief economist Germany and head of currency research at Julius Baer in Frankfurt. Some analysts worry about the continuing effect on markets in the here and now of a socialist government led by François Hollande, and the future effect of a possible win in the 2017 presidential election by Marine Le Pen, head of the far-right Front National. However, Mr Kohl argues that once in power, most parties tend to become more moderate than pre-election rhetoric suggests. 

“It doesn’t really matter who comes to power: there are certain necessities in France that need to be met,” says Mr Kohl. “This is governed not by political but by economic laws.” He notes the socialist government’s pragmatic 2014 decision to appoint Manuel Valls as a business-friendly prime minister. 

One result of this politically safer environment is extremely low yields. This is, for investors seeking adequate yields, a problem – and in response, Mr Kohl suggests euro-based investors seek fixed income opportunities outside the currency union. The March end-of-month spread between 10-year Bunds and US Treasuries was, at 175 basis points, the highest end-of-month spread since 1989. 

The transatlantic opportunities for investment travel both ways, however. “When the dollar was strengthening, clients asked us, ‘why would you invest in the eurozone?’” says Bernie Schoenfeld, senior investment strategist at BNY Mellon WM in New York. His answer: “They’re export superstars. Some of the major European multinationals, such as BMW, happen to be domiciled in Europe but are really global vendors.”

BNY Mellon does not use a currency hedging overlay to protect clients against changes in euro-dollar or other cross rates, in the belief that even on an unhedged basis, eurozone equities look attractive for US investors.  After allowing for the sharp fall in the euro, the MSCI eurozone index was still up 5.2 percent in the first quarter in dollar terms. 

Dollar-based investors should hedge euro exposure, believes Citi’s Mr Sacks, based partly on a more bearish view of the currency. 

“Over the next 12 to 18 months the euro will depreciate to parity against the dollar, and then perhaps 95 cents,” he says. The US Federal Reserve will raise rates in the fourth quarter, according to Citi. In the eurozone, on the other hand, “we believe the first rate rise is at least three years away. There’s quite a bit of divergence there.” 

It is divergences such as these that bring currencies lower – while at the same time making their stockmarkets more enticing.