Europe - from problem child to investors' favourite?
Europe has long been seen as the unloved problem child of the developed markets, beset with fiscal problems, threatened with disintegration and unable to escape from chronic underperformance. Now it is 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 is going the way of the US — down a populist, nationalist and anti-globalisation path. His party’s landslide victory in the recent parliamentary elections has bolstered confidence that perhaps things in Europe are not so bad after all.
Fundamentals have also been improving. Last year, the region expanded faster than the US for the first time since the financial crisis. First-quarter earnings were the best in nearly a decade globally, led by 28% annual earnings-per-share growth in Japan, followed by Europe at 23%. Some 10 out of 11 sectors recorded positive growth in Europe, led by energy and materials. Over the first three months of the year, earnings in cyclical sectors beat defensives. However, after a strong year for cyclical ‘value’ funds last year, there has been a resurgence in performance from defensive stocks, which tend to do better in economic downturns.
As a result, investors are eschewing ‘expensive’ US equities in favour of their European counterparts (figure 3). Flows into European ETFs (passive index-tracking funds) netted $6.1 billion in the first week of May alone, the highest weekly inflow since data provider EPFR began tracking the figures in 2000. However, the headline PE ratio for the MSCI Europe index is 24.3 times. Compare this with a headline PE of 21.7 times for the S&P 500.
According to Bloomberg, assets invested in the $2.2 billion iShares Core MSCI Europe ETF have surged 155% since December 2016. The larger $12.2 billion Vanguard FTSE Europe ETF grew 14% over the same period (to 16 May 2017). The first three months of the year saw the highest quarterly inflows to European mutual funds for five years, highlighting increased appetite among US investors in particular for the region.
Performance has been strong across the board, but we believe investors should be wary at the top end of the market cap spectrum where ETF flows tend to be concentrated. Small and mid-cap companies have also had a strong run, so there is no clear differential in terms of valuations between larger and smaller companies.
So far this year, the MSCI Europe Small Cap index returned 15.6%, the MSCI Europe Mid Cap returned 14.5% and the MSCI Europe Large Cap trailed, up 11.4%. However, should sentiment turn away from Europe and strong inflows into ETFs reverse, the largest companies are likely to suffer the most.
Despite the recent optimism in Europe, headwinds remain. Angela Merkel is on course to win the German elections in September, but political uncertainty remains in Italy. Although an election is scheduled for 2018, there is a risk that former Prime Minister Matteo Renzi will seek an early ballot before the end of this year. Renzi is generally seen as a stabilising force, but the uncertainty surrounding yet another election is likely to feed through to increased volatility in the markets. We believe this situation is currently overlooked by exuberant investors piling in to Europe on a Macron relief rally.
We remain more confident about northern European countries, where companies tend to be more globally focused and balance sheets are stronger. We believe they are in a better position to withstand further geopolitical risk from Europe. Risks to the bond market in Italy and Spain continue to lurk in the shadows, posing another potential risk to recent optimism.
There are attractive opportunities in Europe, but after a period of strong performance and rapid inflows, we are cautious. We favour quality companies and fund managers with a proven track record for stock selection as well as an ability to withstand volatility over the economic cycle.