European equities have enjoyed their finest start to a year since 1989. After trailing US stocks for the last six years, is it turnaround time for the European market?
A growing army of investors appear to believe so, with European indices shrugging off ongoing uncertainty in Greece to record double-digit percentage gains since early January. Inflows into European exchange-traded funds (ETFs) recently hit record levels, helping drive the Euro Stoxx 600 to its highest point since 2007, while the German Dax has been hitting all-time high after all-time high. A number of analysts foresee European gains in excess of 20 per cent for 2015.
Easing
The trigger for this new-found optimism has been the European Central Bank’s belated embrace of
quantitative easing
(QE). Mario Draghi’s announcement of an open-ended monthly €60 billion bond-buying programme comes six years after the Federal Reserve began QE in the US, but investors have decided to take a better-late-than-never attitude.
Will it work? Some say it already has; currency markets had been pricing in the announcement for months, with the euro hitting 11-year lows against the dollar even before the ECB announcement. Corporate Europe generates almost half of its earnings from outside of Europe, so increased exports means a sizable boost to earnings. According to Credit Suisse, a 10 per cent decline in the value of the euro boosts earnings by 8 per cent. The same point is made by JPMorgan analysts, who note that a weak euro is typically followed by an earnings outperformance by European firms relative to their US peers in subsequent quarters.
QE has also helped drive corporate bond yields down to record lows. Today, investment-grade bonds yield just 1.2 per cent, compared with 2.75 per cent in the US. Indeed, Nestlé was recently paid for borrowing money, with yields on a four-year bond turning negative, prompting Deutsche Bank strategist Jim Reid to quip that chocolate may be "the new gold". Overall, record-low borrowing costs should boost 2015 European earnings by another 2 per cent, Morgan Stanley estimates. The collapse in oil prices provides another earnings tailwind, by as much as 7 per cent, says Morgan Stanley. Add it all together – the halving in oil prices, the 15 per cent fall in the value of the euro and the continued decline in borrowing costs – and it "constitutes the most significant easing of financial conditions in the euro area since at least the set-up of the common currency area in 1999", the company says.
Valuations
Bulls also see
valuations
as a supportive factor. It’s not that European equities are especially cheap; they’re not. European stocks trade on 14.2 times estimated earnings, above their 10-year average of 12. Other valuation metrics – price-to-book ratios, price-to-cash flow, dividend yields – are broadly in line with 10-year averages.
However, while European indices are not cheap in absolute terms, they are underpriced relative to the rest of the world. European stocks trade on a 16 per cent price-book discount to global markets, according to Morgan Stanley, just above the 20-year relative low reached in 2012.
The gap between European and US valuations is particularly stark. Between 2006 and 2011, there was little difference between the total market capitalisation of the European and US markets.
Indeed, European markets were worth more than $1 trillion more than the US market. The US has taken off in recent years, however, and is now worth almost $10 trillion more than the European market.
Europe’s cyclically adjusted price-earnings (Cape) ratio, a widely followed metric that averages earnings over a 10-year period, is almost 40 per cent below that of the US.
Historically, Morgan Stanley says, the discount has averaged just 10 per cent. There has, the company says, never been a valuation gap as great as today’s.
There are some obvious caveats. Firstly, around a fifth of the US market is made up of technology stocks, which invariably merit higher earnings multiples due to their outsized profit margins.
If one adjusts for the sector make-up of the different indices, the valuation gap narrows.
Secondly, the US market has merited a higher valuation in recent years because of its superior earnings outlook. Since 2008, US corporate earnings have risen by 19 per cent, JPMorgan says, while European earnings have fallen by 24 per cent.
Earnings rebound
However, European earnings cannot remain depressed forever. Earnings are well below their 10-year averages, so there is obvious potential for a profits rebound.
Increasingly, strategists believe that the long-awaited turnaround is under way. A profits pick-up was noticeable in third-quarter earnings in 2014, even if it was entirely due to cost-cutting – revenues actually contracted slightly. Aggressive cost-cutting means any small increase in revenues “can quickly translate into stronger bottom-line growth”, says JPMorgan.
The consensus among analysts is that Stoxx 600 company earnings will rise by 7.3 per cent this year, more than double the 3.4 per cent rise envisaged for the US. (Not since 2008 have European earnings outpaced the US.)
Additionally, investors are “fatigued” by US equity valuations and the fear of earnings downgrades, said Merrill Lynch analysts recently. This confluence of factors has meant investors have been busy rotating out of the US and into Europe in 2015, with January being the worst month for the US market in a year.
Headwinds
Even staunch Europe bulls will admit that obvious headwinds remain. In the near term, the obvious one is Greece. Political risk is likely to remain a concern in 2015, given that further elections are due in Spain, Portugal, Finland and the UK. The threat of deflation, too, is unlikely to recede any time soon. Over half of the Stoxx 600 companies are domiciled in countries where inflation is lower than 1 per cent, JPMorgan says, while 25 per cent of the index is based in countries suffering outright deflation.
Furthermore, one could argue that European stocks are due a breather, having advanced by more than 15 per cent since mid-December. Further big gains require either a continued jump in valuations or a large earnings surprise.
However, bulls will argue that recent market action is reminiscent of the US in 2013 and 2014, when all news was interpreted as good news. This year may be Europe’s turn for a “bad news is good news” period, with investors jumping on poor data as an excuse for continued monetary stimulus.
There is also the “Tina” argument – there is no alternative. European equities offer a dividend yield of 3.7 per cent, compared with 2 per cent in the US. Meanwhile, government bond yields offer next to nothing, while investment-grade corporate bonds are little better.
Then there are the aforementioned tailwinds: QE, a plunging euro, lower oil prices, relatively low valuations and the potential for an earnings rebound. After six years of underperformance, bulls believe the recent rotation into Europe is just the start.
