Can investors continue to find value in Europe’s equity markets?
European equities have been in fashion this year, but their popularity may be waning as valuations become less attractive and signs emerge that economic growth may have peaked.
Investment inflows have been particularly strong since the market-friendly Emmanuel Macron was elected France’s president. When his newly created ‘En Marche’ party won a sweeping majority in Parliament a few weeks later, snapping up 351 out of 577 seats, financial markets had another reason to celebrate.
Although the Macron trade has cooled and the young President’s popularity has fallen faster than any of his recent predecessors, capital is still flowing into European equities. Some €20 billion had poured into the asset class in the year to late June, significantly more than the €16 billion that investors had put into US equities. Notably, eurozone equities only came back into positive territory at the end of June after outflows suffered in 2016, so there could still be some momentum in this trade.
Actively seeking value
The question for active investment managers seeking to outperform the broader market is where to find value in European equities? At the end of the first quarter, European companies beat earnings forecasts by posting their best results in a decade. However, second-quarter earnings were more tempered.
The short-term leading indicators that we monitor suggest economic growth in Europe peaked in the second quarter. The IFO survey (a popular measure of economic developments in Germany) suggests the growth rate could stay where it is for the rest of the year. Meanwhile, data from purchasing managers indices (PMIs) of business activity has been more negative, suggesting a slight deceleration.
Our preferred indicator is the Belgium business confidence survey because it includes only a few intercontinental exporters and so gives a clearer gauge of domestic dynamics — the latest reading echoes the PMI data by suggesting the pace of growth is slowing (figure 4).
Figure 4: Feeling less confident
The Belgium business confidence survey is a reliable measure of Europe's economic health and the latest readings suggest the pace of of growth is slowing.
Source: Datastream and Rathbones
Monetary dynamics have also become less supportive: inflation-adjusted growth of money supply has slowed, and our favoured gauges of private sector borrowing have weakened sharply (figure 5). New lending to firms is still very weak outside of Germany and France and there is still a lot of bad debt hanging over from the previous decade’s excesses — only Spain has significantly reduced debt since the crisis.
Inflation pressure is still weak, and may weaken further if the euro stays strong. There is more slack in eurozone labour markets than in other developed economies and wage pressures are likely to remain subdued. So if inflation is likely to remain low, leverage is still high and growth is decelerating, the European Central Bank (ECB) is unlikely to be increasing interest rates in the foreseeable future, which might mean bond yields are peaking.
This has implications for asset allocation because for the past 10 years or more Europe has only outperformed global equities when German Bund yields were rising. At the same time this does mean little risk of a negative surprise from rising rates.
Is debt a concern?
Similarly, Europe only tends to outperform global peers when value stocks (more cheaply valued equities) outperform — and ‘value’ is stuffed full of financials at present. This brings us back to the question of value in European equities: financials are one of the few areas where valuations look inexpensive, yet they will struggle to grow earnings in an environment where interest rates are extremely low and not expected to rise for the foreseeable future.
Financials account for 22% of Europe’s stock market and banks comprise roughly half of this weighting. The financials sector is not only the largest in the index, it is also pivotal for the outlook for many underlying economies. According to our research, many eurozone markets are extremely sensitive to the performance of banks — in fact, even more sensitive than the weight of banks in the index would imply. What this means for investors is that if something were to happen to derail banking sector performance, it would affect the wider economy.
Financials and consumer discretionary shares are expected to account for more than a third of European earnings growth over the next 12 months, according to consensus estimates from analysts — so to have a positive view on Europe requires a positive view on these sectors.
Banks’ net interest incomes have recovered this year but non-interest income has not — if bond yields have peaked, bank income may roll over too. Non-performing loans — which clog up bank balance sheets, drag down return on capital and restrict the capacity to extend new loans — have declined everywhere bar Italy, where 15% of all loans are delinquent, and, to a lesser extent, France.
However, provisions made against expected losses on delinquent loans are still eating into banks’ operating income. In Italy, provisions being set aside for loan losses still equal 50% of pre-provision operating income; in Germany and Spain they account for 40%. In short, bad loans are still severely compromising business models.
Figure 5: Money supply
The inflation-adjusted (real) supply of money in the eurozone has fallen recently, which suggests the rate of economic groth may have peaked.
Source: Datastream and Rathbones
In our view, European bank stocks should be even cheaper than they are at the moment. The MSCI Europe Financials index is trading on 18.6 times forecasted earnings for the next 12 months, which is not a great deal less than 20.2 times for the wider MSCI Europe ex UK index. The S&P 500 Financials index is trading on 15.2 times by comparison. The consumer discretionary sector is relatively inexpensive, trading on 15.7 times forecasted earnings.
One concern we have for consumer stocks is that leading brands will not carry the weight they did in the world before Amazon. The potential for Amazon to eat into the market share of established companies is immense and yet to be tested.
Although we think European equities have reached their zenith in terms of earnings growth in the near term, political risk is not as high as some might think. Beyond President Macron, whose labour-reform policies are controversial in France, the political environment looks the most stable we have seen since the euro crisis in 2011. Most recently, Angela Merkel has won a fourth term as German Chancellor.
Financial markets are likely to experience some volatility ahead of Italy’s elections, which are due to be held before next April. The anti-establishment 5Star Movement is losing ground, but even if the party were to get into government, polls show Italians largely support the euro, ECB and other EU institutions. So in any referendum on euro membership held in the next 12 months, the country is unlikely to vote against the status quo.
The political environment is better than it has been for European companies for years. But we find it difficult to be positive on European equities without an acceleration in global growth, rising bond yields and an improving outlook for the financials and consumer discretionary sectors. What looks like value in European equities may not be such a great buy after all, when you consider the growth prospects.