Europe has long been seen as the unloved problem child of developed markets, beset with fiscal problems, threatened by disintegration and unable to escape from chronic underperformance. Now it’s the new favourite. But can Europe justify its new-found popularity and higher valuations?
Centrist Emmanuel Macron’s decisive victory in France’s presidential election earlier this year was enough to stave off investors’ fears that Europe was going the way of the US – down a populist, nationalist and ultimately anti-globalisation path. His party’s landslide victory in the recent parliamentary elections only serves to shore up confidence that perhaps things in Europe are not so bad after all.
Economic fundamentals have also been improving. Last year, the eurozone expanded faster than the US for the first time since the financial crisis. Globally, first-quarter company earnings were the best in nearly a decade. European earnings were 23% higher than a year earlier, the second-fastest growing region behind Japan. This Continental resurgence is broad-based too, with 10 out of 11 sectors recording growth. Energy and materials delivered the strongest earnings expansion, while telecoms were the laggard.
Rays of sunshine have been few and fleeting in Europe, and the recent good news comes at a time of sky-high indices and political uncertainty in the US. As a result, investors are eschewing ‘expensive’ US equities in favour of ‘cheaper’ European counterparts. That perceived value may be a popular misconception, however: MSCI Europe’s P/E is 24.1x, compared with 21.6x for the S&P 500. That hasn’t stopped investors though. Index-tracking funds (ETFs) in Europe hit a milestone in May, netting $6.1bn in inflows in the first week alone – the first time flows reached this level since EPFR starting tracking data in 2000.
According to Bloomberg, assets invested in the $2.2bn iShares Core MSCI Europe ETF have surged 155% since December. The larger $12.2bn Vanguard FTSE Europe ETF grew 14% over the same period (to 16 May, 2017). The first quarter saw the highest quarterly inflows in European mutual funds for five years, highlighting increased appetite among US investors in particular for the region.
This is a lot of money flowing very quickly. Performance has been strong across the board, but we think there is a risk that the money could flow out just as quickly. Should sentiment turn away from Europe and strong inflows into ETFs reverse, the largest – the most liquid – companies are likely to suffer the most. Sources of potential disappointment are many: German elections are in September, the European Central Bank is trying to walk the tightrope of setting policy for a two-speed continent and Mr Macron will be hard-pressed to live up to the hype created by his rise to the French presidency. By far the largest question on the horizon is posed by Italy.
At the latest, Italy will go to the polls in May. However, there is a risk that former Prime Minister Matteo Renzi will seek an early ballot before the end of this year. Managers tend to believe a Renzi victory would be a stabilising force but the uncertainty surrounding yet another election is likely to feed through to increased volatility in the markets, something we believe is currently overlooked by exuberant investors piling in to Europe on a Macron relief rally.
There are opportunities in Europe, but after a period of strong performance and rapid inflows, we are cautious.