Quantitative easing and weak euro boost European stockmarkets

European stockmarkets have performed staggeringly well, doubling in value since 2009, of which 18 per cent was in the first quarter of this year. GDP forecasts for 2015 have already been revised upwards to between 1.4 and 1.5 per cent from 1 per cent at the turn of the year, with growth next year expected to approach 1.75 to 2 per cent. However, not much more can be achieved purely by way of a rerating and future share price rises now depend on improved corporate earnings and the success of quantitative easing in transforming the underlying economy.

While QE is generally considered a positive driver for the next six months, it is anticipation that is the primary driver. The Japanese and US experiences cast doubt on its ability to sustain economies longer-term.

“The underlying improvement to the economy could take years, not months, to come through,” points out Daniel Kranson, portfolio manager at Vontobel Asset Management. “In the US there have been three rounds of QE and the Fed is still debating whether to raise rates, because there is still uncertainty around the strength of the economy and if it could sustain higher rates.” 

A pattern is emerging, however. In the US, yields rose shortly after the asset purchase programme and we are beginning to see a similar story in the eurozone, with German bunds moving from 5 basis points to 59 basis points, in line with the ramp-up in asset purchases.

Those who believe there is further opportunity for price expansion expect it to come from the profit cycle, following a crop of upward earnings revisions.

“For the first time in five years we can see that earnings expectations are realistic,” says Thorsten Winkelmann, senior portfolio manager for European equities at Allianz Global Investors in Frankfurt. 

Over the past five years, earnings growth expectations were always too high and needed to be revised downwards over the course of each year, mostly ending up in negative earnings growth, he explains. For 2015, earnings expectations seem more realistic and the first positive revisions were seen April. 

“This bodes well for a fundamentally strong year for European equities, where stock prices are driven by underlying earnings growth,” says Mr Winkelmann. “This is very different to 2013, for example, where returns were driven purely by a rerating and valuations rose from 8 or 9x at the start of the year to 17x at end of year.”

 Exporters have welcomed the weakness in the euro, particularly those exposed to the US, where the strong dollar has further weighed in their favour. 

Fifty per cent of European companies’ sales are outside the eurozone, points out Maximilian Anderl, managing director, head of concentrated alpha at UBS Global Asset Management. “If the euro weakens, that increases both earnings and cash flows, and additional cashflow can be used for deleverage, M&A and share buybacks.”

However, it would be a mistake to let currency weakness take all the credit. Much of the growth is also being driven by the banking sector. Lending to non-financial corporations began to uptick in November, shortly after the asset quality review wrapped up. According to the ECB, loans to NFCs have risen from €4.27tn in November to €4.3tn as of March.

 “The euro does not need to depreciate to keep businesses competitive,” says Brian Jacobsen, chief portfolio strategist at Wells Fargo Asset Management. “The euro going back up to $1.10 or $1.20 will not compromise the competitiveness of euro exporters. In fact, back in 2012 the euro traded at $1.25 and then it went up to $1.40 at the end of January (2013), but even though the euro strengthened, the MSCI Europe index advanced nicely. And as the currency appreciates, so US investors will see great opportunities, stocks advancing in euro terms, coupled with the currency strengthening, produces a double benefit.”

European stocks are particularly high yielding on a 3.3 per cent forward basis. Many fund managers have therefore overweighted sectors such as pharma. Novartis, for example, yielded 4.5 per cent a few years ago when German 10-year bunds were at 3 per cent, but it is now paying 2.9 per cent (as its forward PE has pushed up to 18x). An overweight in these stocks is seen as foolish by those managers who do not believe in the new earnings optimism.

“Europe is in an unusual position because it has put in a significant performance since the start of the year, while the earnings of its companies are stagnating at best,” warns Alexei Jourovski, managing director and head of equities at Unigestion. “Rock bottom interest rates favour high yielding companies but should rates in the US go up, companies which have enjoyed many years of rising prices could be in trouble.” 

Fund managers have also been buying up consumer discretionary stocks, citing encouraging data such as a rise of 3 per cent in retail sales in Europe, and an 8.6 per cent rise in auto registrations in the  first quarter. 

However, the impact of the wall of money that has hit Europe since the turn of the year began to slow in April on uncertainty around Greece, although most of the nation’s debt is in the patient hands of institutional investors and the public sector. 

“Greece is more of a short-term stumbling block than a long-term impediment,” says Paul Wild, manager of the JOHCM Continental European Fund. “There is no agreement on fiscal targets and large redemption payments are due in May to the IMF and to the ECB in July. The big positive in the Greece situation is that domestic polls say the Greek people want to stay in the eurozone. We feel comfortable that the ECB’s €60bn a month is a powerful tool in terms of containing any contagion.”

Governments and national banks have had years to prepare for a Greek exit. 

“If Greece ever wants to leave the euro, now is the best time to take the pain,” adds Mr Anderl at UBS. “Most people have no exposure to Greece, Europe is recovering and the ECB has unleashed QE – it is more a sentiment risk and the market should recover quickly with the support of the ECB and European Stability Mechanism. We would expect bond yields to spike up for a few weeks and fall soon after.”

Elsewhere in Europe, debt levels are still rising. “The weak euro will help but, on its own, will not stimulate growth sufficiently to stabilise debt levels,” says Toby Gibb, investment director at Fidelity. “My central scenario for Europe is, therefore, likely stagnation in France and Italy, an improving Germany, and increasing political risk due to the rising influence of broadly anti-European parties. Syriza is the first to come to power, but Podemos in Spain and the Front National in France are also strong in the opinion polls and weak on economic agenda.”

However, backing for Podemos is losing its initial momentum and is beginning to plateau, losing 5 percentage points from February, while Ciudadanos continues to rise rapidly with an increase of more than seven points over the same period. This has reduced the likelihood of Spain following Greece’s path. Furthermore, unemployment has fallen and the housing market is improving, creating opportunities for Spanish companies with exposure to the domestic market. 

The German market is also favoured, but was hit in the second half of last year by the Ukraine crisis, improving this year as the rouble strengthened. The emergence of a re-invigorated German consumer is also encouraging. Germany’s biggest trade union has just agreed a 3.4 per cent wage rise and retail sales are picking up.

“The German market is quite wide and has defensive characteristics, which include being export-driven, diversified, resilient, with a solid economy,” says Mr Jourovski at Unigestion, whose fund is 4 per cent overweight Germany.

QE is however a blunt tool, with ample potential for unintended consequences. “QE could take the pressure off economies such as Italy and France that have not enacted major reforms, whereas we have seen strong improvements in countries like Ireland and Spain that took hard steps in the depth of the crisis,” says Vontobel’s Mr Kranson. There is also a serious risk of the current low cost of capital being used to justify investments that would not in normal circumstances make sense, he warns.

The greatest opportunity for Europe could also be the biggest threat if the euro starts to retrace its recent weakness. “A really long-term risk is to export industries in countries such as Germany and Switzerland which have successfully competed despite strong currencies by focusing on quality and cost control. In an environment where currencies stay weak for an extended period, self-discipline could falter,” adds Mr Kranson.

The market is split in its views on eurozone financials.“We remain cautious and feel the sector’s positive performance since the QE announcement is unjustified – while low interest rates certainly reduce deposit costs, they also reduce returns on loans and securities portfolios,” says Mr Gibb. “A reduction in sovereign spreads will also impact net interest margin securities. Our focus remains on non-eurozone banks where risk/reward is far more attractive.” 

Renewed confidence

For the last few years, Barclay’s Wealth has been recommending both US and Continental European equities. But the end of 2014 saw the bank move European equities ahead of their US peers in terms of preference, explains Will Hobbs, head of European investment strategy. 

The burgeoning European economic recovery seen in 2014 ran into trouble mid-year in large part as a result of the Russian conflict, he explains, but at the end of last year business activity started to pick up again, helped by the ECB’s work in rebooting the transmission system over the course of 2014.

“There is an appreciable risk that the latest Minsk agreement does not hold. Ukraine’s drift towards Western institutions is still likely unpalatable to Russia, suggesting that investors would be wise to keep an eye on the region,” says Mr Hobbs.

“In our portfolios, we are slightly long European equities at the moment,” says Cesar Perez, global head of investment strategy at JPMorgan Private Bank. The underlying strategy is to focus on dollar earners, such as retailers that sell abroad – a tilt to the US in particular is preferred. Additionally, there are companies in Europe that will benefit from the dividend yield pickup, he says. 

The dividend theme is still a proxy for fixed income with dividend growers that offer a sustainable dividend, although investors might still want to avoid regulated industries, says Mr Perez. “We are also on the lookout for the pockets of the market which benefit from a weaker currency and are not overly exposed to what remains an overall weak domestic consumption picture across the eurozone. The exception is Germany, where consumption has already started picking up as a result of currency depreciation. This is a development which might help the wider market.” 

Furthermore, he believes an increase in stock buybacks or cross border M&A as a result of low rates is another positive catalyst which might play out this year.

Active and passive investments play equally important roles in the bank’s  portfolio construction process, explains Mr Perez. “It’s a matter of finding the right mix. Regarding European equities, we prefer using managers who are able to take tactical bets on longer term trends and have the ability to react quickly to market volatility.”

Julius Baer remains positive on equities in general, says Christoph Riniker, head of equity strategy research at the Swiss private bank. “Valuation within the asset class is neutral by now but compared to other asset classes we still would call it attractive. We prefer European equities to the US.”

Within Europe the bank clearly favours eurozone peripherals and is overweight both Italy and Spain. In Switzerland it is neutral, and underweight in the UK.

 “We clearly express our preference for eurozone peripheral markets, focusing on Italy and Spain, which is based on some euro strength going forward,” adds Mr Riniker. “In terms of sectors we still prefer cyclical exposure as we believe an overall constructive environment for equities is positive for sectors such as consumer discretionary, information technology and financials.”

View from Morningstar: Solid returns and healthy inflows

With low interest rates and the return of investor confidence in Europe, over the last three and five year periods (up to April 2015), funds in the Morningstar Europe Large-Cap Blend category posted an average annualised return of 17.04 per cent and 10.78 per cent respectively (in euro terms).

Compared to 2014, when we saw funds in most of the European equity categories posting modest figures, 2015 began with solid returns. In addition, during the first three months of the year, funds in Europe Equity Large-Cap categories gathered more than €18.2bn in net inflows from investors around Europe. 

UBS (Lux) ES – European Opportunity Unconstrained fund, which holds a Morningstar analyst rating of Bronze, is one of the top European equity performers over three and five years. This product is a long-short version of the UBS European Opportunity fund, also rated Bronze and is managed by Maximilian Anderl and Jeremy Leung. 

The fund invests primarily in European large caps, with the particular feature that the investment ratio can be up to 150 per cent on the long side and 50 per cent on the short side (135 per cent and 35 per cent normally). The net equity market exposure is usually around 100 per cent and the portfolio comprises approximately 80 long and 60 short positions.

Another fund that has done a good job for investors historically is the Allianz Europe Equity Growth (rated Bronze). This product has been managed by Thorsten Winkelmann since October 2009, in close collaboration with Matthias Born and co-manager Robert Hofmann. Companies with high, long-term profit and cash flow growth form the focus of their stockpicking approach. The managers make a distinction between structural and cyclical growth, with companies demonstrating structural growth taking priority in their approach.

Other funds Morningstar likes in the European equity universe include the disciplined low volatility oriented Uni-Global Equities Europe (rated Gold) and Nicolas Walewski’s flexible Alken European Opportunities Fund (rated Silver). The Morningstar analyst rating is based on the analyst’s conviction in the fund’s ability to outperform peers on a risk-adjusted basis over the long term, and these two funds score positively in most of the pillars considered in our analysis  – process, performance, people, parent and price). 

Álvaro de Liniers, fund analyst, Morningstar