By Jeremy Schwartz, CFA, Director of Research & Tripp Zimmerman, CFA, Research Analyst
Europe's economy experienced six straight quarters of negative economic growth-or contraction-before returning to a positive growth rate-or expansion-in the second quarter of 2013. The European recovery has been supported by accommodative monetary policies, low inflation and a moderation in fiscal austerity. Consumer spending has improved, and manufacturing surveys are pointing toward expansion. This stabilization of the European economy is encouraging, and in the second half of 2013 many investors quickly acted on these green shoots by allocating over $20 billion to European-focused exchange-traded funds (ETFs) in their search for investment opportunities.
In this research piece, we explore the following topics:
- How the economic recovery can support earnings growth, given progress along the economic cycle
- A rigorous valuation analysis shows that two of the cheapest countries in Europe today are also two of the largest and most important: the United Kingdom and Germany
Early Stages Of Economic And Earnings Recovery
Some may be hesitant to allocate to the region after the strong equity performance we saw in 2013. One reason to have a continued positive view of European equities is that the current stage of the economic cycle-being very early in the economic recovery-may imply the earnings cycle is about to ramp up to a higher gear. We graphed year-over-year growth in the economy against the MSCI Europe Index's and the MSCI Europe Small Cap Index's earnings per share to highlight how Europe's earnings have responded to growth or contraction in the economy over the last 10 years. The graph shows a tight correspondence of earnings levels with growth and contraction in the economy.
Earnings Cycle Just Getting Started: It is important to remember that Europe's economy is just starting to show signs of growth, and this recovery has not yet shown up in corporate earnings-at least on a trailing 12-month basis. We are starting to see a pickup in earnings expectations, as illustrated below through differences in estimated price-to-earnings (P/E) ratios and trailing 12-month P/E ratios. But trailing 12-month earnings for MSCI Europe would have to grow over 76% to reach the highs of 2007, and over 31% to reach the most recent highs of 2011. Putting this in perspective, both the S&P 500 and MSCI Emerging Markets indexes have already surpassed their pre-recession earnings highs.
Small-Cap Earnings Display Higher Volatility: Small caps tend to be more economically sensitive in periods of economic growth as well as contraction, so it is not surprising they display a higher variability in earnings. Although the recent earnings growth for the MSCI Europe Small Cap Index has been greater than its large-cap peer, earnings would still have to grow over 69% to surpass the 2007 highs.
Economic Growth Turned Positive: The most recent quarter-over-quarter gross domestic product (GDP) print was positive 0.2%, and it marked the third quarter of positive growth after six quarters of contraction, pushing the year-over-year change to positive 0.5% growth. Since the second-quarter GDP reading, there have been improvements in the Purchasing Managers' Index (PMI), with multiple readings above 50 and trending higher, typically a sign of economic expansion. As a result, many economists are forecasting the eurozone to continue with positive economic growth, which can potentially flow through to better growth in earnings.
Long-Term Earnings Estimates
Although the global macroeconomic headwinds can create uncertainty for Europe's growth, Ned Davis Research shows analysts are fairly optimistic about future growth expectations of European companies, in particular small-cap European companies.
European Small Caps Currently Have Higher Growth Expectations: Small caps offer a higher than 3 percentage point advantage over large caps in long-term earnings growth estimates. Although European small caps are currently trading at higher valuations, as displayed below, we think the growth premium could be worth paying up for if one is optimistic about the region's economic and earnings recovery.
European Small Caps Exhibit Double-Digit Growth Expectations: According to analyst estimates, broad European small-cap companies are expected to have long-term earnings growth above 13%. It is important to note that this growth is primarily led by three of the largest European economies (Germany, France and the United Kingdom), all currently exhibiting double-digit growth among small caps. It is also important to note that the average growth premium for small caps in these countries is around 7 percentage points higher than for large caps.
European Equities Selling At A Discount To Historical Averages
With the various issues plaguing Europe, it isn't surprising that equity market valuations have been depressed. Yet given the general feeling that the worst of the European crisis may be behind us, allocations to Europe have been increasing, and certain markets experienced strong gains in 2013.
Some may feel they missed the rally or that valuations are stretched. Yet if the earnings cycle is just starting to turn up, there could still be opportunities for growth in earnings, as discussed above. To provide context for the current valuations, we compare both the trailing and estimated price-to-earnings (P/E) ratio for countries and sectors to their historical medians.
Estimated Earnings Improvement Strong for Europe: Of the major regional large-cap indexes, the MSCI Europe Index showed the largest improvement in the estimated P/E ratio, thus signaling the greatest expectations for earnings growth compared to the S&P 500 and MSCI Emerging Markets indexes. Looking down the capitalization spectrum, the MSCI Europe Small Cap Index is also signaling significant improvement in expected earnings.
Within Europe, the best improvements in expected earnings look to be in Italy and Spain, which have elevated P/E ratios on a trailing 12-month basis but see more normalized earnings and valuations in line with the rest of Europe. It is important for these two countries to begin normalizing, because they have been responsible for some of the greatest headwinds for the European economy.
European Small Caps with Larger Historical Discount Than Large Caps: Compared to its historical median the MSCI Europe Small Cap Index's estimated P/E ratio showed a discount of 44%, greater than the MSCI Europe Index discount of 23%. To be fair, the MSCI Europe Index had a lower absolute valuation, but small caps typically sell at higher valuations than do large caps as a result of their higher growth expectations. European small caps also sell at a discount compared to U.S. small caps, whose estimated P/E ratio is almost 50% greater than that of European small caps.
United Kingdom, Germany, France Lowest-Priced Markets: Looking within the individual country markets, we notice the United Kingdom and Germany leading the way with the lowest estimated P/E ratios-just above 13x earnings and about 8% and 6%, respectively, lower than Europe's valuation as a whole. Both countries being among the region's top economies, it is interesting that they also have the lowest current valuations. If one looked for the highest discount to its historical median, France takes the spot, followed closely by the United Kingdom. France also happens to have the third lowest estimated P/E ratio.
From Countries to Sectors: We now extend this analysis of P/E ratios from countries to sectors.
All Sectors Trading Below Historical Median: All sectors are trading below their historical medians. It is interesting that the Telecommunication Services and Health Care sectors display some of the largest discounts to their historical medians, given the fact that these sectors are typically more defensive and have a tendency to be favored during uncertain economic environments.
The lowest estimated P/E ratio sector is Energy, and this is a phenomenon that is true across all global regions today, including the United States and the emerging markets.
Earnings Improvement Visible in All of Sectors: The price-to-earnings ratio comprises two components: price and earnings per share. It is important to keep this in mind, because at times a price-to-earnings ratio might appear low due to a falling price, while at other times it could appear low because of quickly increasing earnings per share. Since most of the sectors displayed above have experienced positive price appreciation over the past year, most of the improvement in the estimated price-to-earnings ratio is due to expected increases in earnings per share.
Comparing European Equities To European Bond Valuations
In addition to looking at how Europe's valuations compare to their own historical averages as well as to other major regions, another way to view the attractiveness of equities is to compare them to another major asset class: bonds. One model for gauging equity valuations-dubbed the "Fed Model"-compares the earnings yield (E/P ratio, or the inverse of the P/E ratio) to a long- term bond yield.
There are clearly different risks associated with equities than with bonds, but essentially we judge the relative value of one security against another and against their respective historical medians. We look at the current earnings yields, bond yields and the spread11, and the median of the same period examined above, for the 10 largest developed countries in Europe as well as for the United States (for comparison purposes):
- A higher earnings yield indicates a lower valuation, because investors are essentially getting more earnings per share, so countries that exhibit a higher earnings yield are more attractively priced compared to their own history.
- The same holds for countries that currently have a higher earnings-yield-to-bond-yield spread; when comparing asset classes, these countries are currently selling at lower relative valuations compared to their own history.
Germany and United Kingdom with Highest Earnings Yields: Just as Germany and the United Kingdom had the lowest P/E ratios, they have the highest earnings yield, both over 7.0%.
- At 5.84%, Germany has the single largest spread between its earnings yield and its bond yield. The 10-year German bund current yield is 1.57%, compared to its historical median of 3.92%. The spread between equities and bonds is over twice its historical average.
- The United Kingdom historically had an earnings yield spread over bonds of just over 1%, but the current spread is 4.78%. This is because the bond yield is 1.75% below its 10-year median at the same time as the earnings yield is 1.75% above its 10-year median.
Current Earnings Yields and Earnings Spreads Higher Than Historical Spreads: Looking across the different countries, we notice that, compared to their historical medians, the current earnings yields are higher in eight out of the 10 European countries and the spread between earnings yields and bond yields is higher in ten out of the 10 countries.
Higher Earnings Yield Than United States: The four largest European economies (Germany, France, the United Kingdom and Italy) currently have a higher earnings yield than the United States, and three of those countries have a higher current spread. We feel this further confirms that there is opportunity in the European region.
Further Valuations Statistics
When making allocation decisions, we feel it is important to have a well-rounded view of different valuation statistics. Having discussed price-to-earnings ratios, their corresponding earnings yields and the spreads over bonds, we extend our analysis to dividend yields and price-to-book ratios in the table below to round out the valuation study.
Europe Valuations Led Regional Markets: The MSCI Europe Index is currently trading at more favorable valuations when we look at dividend yield or price-to-book ratios compared to historical medians against the S&P 500 and MSCI Emerging Markets indexes. When looking at dividend yield, we see the 1.56% and 0.77% advantage the MSCI Europe provided over the S&P 500 and MSCI Emerging Markets indexes, respectively. Given this significant yield advantage, we feel it is important for investors to consider European equities, especially given the desire for current income in today's low interest rate environment.
Europe Small-Cap Valuations Relatively Attractive: The MSCI Europe Small Cap Index is currently trading at more favorable valuations when looking at dividend yield or price-to-book ratios compared to the Russell 2000 Index. When looking at dividend yield, we see a 1.01% advantage for the MSCI Europe Small Cap over the Russell 2000 Index.
Dividend Yield Advantage: Most of the countries and sectors displayed above had a greater current dividend yield than their historical medians. The MSCI Spain Index had the highest country dividend yield and one of the highest advantages compared to its historical median.
Financials and Italy with Lowest Price-to-Book Ratio: It isn't surprising to us, given the recent European debt and bank crisis, that the Financials sector is still trading close to book value. Italy, as a whole, is trading close to book value, over a 40% discount to its historical median.
Potential Headwinds Or Risks To European Allocations
While the valuations discussed above show European markets to be very reasonably priced-especially if we are early in an economic recovery and earnings growth is starting to pick up. Yet this is not to say European risks are minimal. The road to recovery may be an uphill battle in light of a continuous rise in unemployment, falling inflation and, finally, potential euro strength, which hurts European exporters and has the potential to hamper the recovery.
It has been over a year since the head of the European Central Bank (ECB), Mario Draghi, pledged to do "whatever it takes" to save the euro, which ultimately helped relieve market anxiety and lowered borrowing costs for the peripheral countries. Late last year, the ECB offered a form of forward guidance by adding "an extended period of time" to their policy statement, and then more recently, November 2013, lowered interest rates from 0.50% to 0.25%. Although these are positive events, further accommodation could be provided by the ECB, and that should provide further tailwinds for the economy and, ultimately, for equities.
Europe has been one of the primary risks for the global economy-with sluggish growth, over-leveraged countries and banks being a prime concern for many investors. With these concerns and risks, it may be no surprise that Europe looks attractive from many different valuation viewpoints, compared to other regions and even its own history. We know that some of the best long- term investment decisions are made during times of uncertainty and typically when sentiment is still pessimistic. In general, we are optimistic in regards to Europe. If Europe's economy can expand upon its recent growth, it could be very supportive for future earnings growth and the regional equity markets. We also understand the importance of diversifying and feel there are different ways to play the European recovery theme, depending on one's conviction.
Small Caps for Higher Beta: If one believes Europe is recovering, we'd encourage a look at small-cap companies, which are more sensitive to trends in the economy because of their cyclical exposure and are more highly leveraged to economic growth. In other words, small caps often have higher beta-or market reactions-to both the ups and downs in the markets.
A Focus on Large-Cap Exporters: If the euro weakens, we'd encourage a look at large-cap exporters, which have diversified revenue streams and are not overly dependent on a single economy. These companies may benefit from global economic growth and could be more insulated if the European recovery does not materialize.
Single-Country Exposure: Two of the largest European economies, Germany and the United Kingdom, look attractive across all the valuation statistics reviewed above compared to other regional countries and the United States. Typically one might expect to pay a premium for the more stable and larger drivers of regional growth.
Blended Currency-Hedged Approach: Blending exposure to stocks with a currency hedge with exposure to those that do not have a currency hedge could have the potential to minimize the risk of being on the wrong side of a currency's performance. Historically, exposures to the euro and the pound have exhibited significant volatility that didn't result in commensurate returns. For those unsure of which direction the euro or pound may move in the near term, considering a blend that is 50% long and 50% hedged against the currency would yield positions that could benefit no matter which way the currency may go.
Without question, we feel investors could benefit by including exposure to European equities in a diversified portfolio over the long term. With potential economic green shoots perking up in the European landscape, the time could be ripe to consider the tools and options available across European equity indexes. We have already started to see these increased expectations starting to be reflected in the equity markets, and it has started to cause some investors to consider they might have missed the opportunity. After reviewing the economic picture, potential headwinds and current valuations, we feel that the recovery is still in the early stages and valuations are attractive compared to historical medians. We also feel it is important to revisit these valuations going forward and to invest in indexes that take relative valuations into account through a fundamental rebalancing process.
Unless otherwise stated, data source is WisdomTree.
Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, call 866.909.WISE (9473) or visit wisdomtree.com. Read the prospectus carefully before you invest.
Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.
Investments focused in Europe are increasing the impact of events and developments associated with the region, which can adversely affect performance. You cannot invest directly in an index.
Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility.
Investments in emerging, offshore or frontier markets are generally less liquid and less efficient than investments in developed markets and are subject to additional risks, such as risks of adverse governmental regulation and intervention or political developments.
WisdomTree Europe Hedged Equity Index: Designed to provide exposure to European equities while at the same time neutralizing exposure to fluctuations between the euro and the U.S. dollar. Constituents are dividend-paying European firms deriving a least 50% of their revenues from outside Europe. Weighting is by cash dividends paid. WisdomTree Europe Hedged Equity Index: Designed to provide exposure to European equities while at the same time neutralizing exposure to fluctuations between the euro and the U.S. dollar. Constituents are dividend-paying European firms deriving a least 50% of their revenues from outside Europe. Weighting is by cash dividends paid. WisdomTree Europe SmallCap Dividend Index: A fundamentally weighted index meant to measure the performance of small- cap European dividend-paying equities, weighted by cash dividends paid. MSCI Europe Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of developed equity markets in Europe. MSCI Europe Small Cap Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of developed equity markets in Europe, specifically focusing on the small-cap segment of these equity markets. MSCI Emerging Markets Index: A broad market cap-weighted index showing the performance of equities across 21 emerging market countries defined as "emerging markets" by MSCI. Russell 2000 Index: Measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000 Index, representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. S&P 500 Index: A market capitalization-weighted benchmark of 500 stocks selected by the Standard and Poor's Index Committee, designed to represent the performance of the leading industries in the United States economy. MSCI Germany Index: Designed to measure the performance of the large- and mid-cap segments of the German equity market. With 53 constituents, the index covers about 85% of the equity universe in Germany. MSCI United Kingdom Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of the United Kingdom equity market. MSCI France Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of the French equity market. MSCI Italy Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of the Italian equity market. MSCI Netherlands Index: A free float- adjusted market capitalization-weighted index designed to measure the performance of the Dutch equity market. MSCI Switzerland Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of the Swiss equity market. MSCI Spain Index: A free float-adjusted market capitalization- weighted index designed to measure the performance of the Spanish equity market. MSCI Sweden Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of the Swedish equity market. MSCI Denmark Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of the Danish equity market. MSCI Belgium Index: A free float-adjusted market capitalization-weighted index designed to measure the performance of the Belgian equity market. MSCI Europe Health Care Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Health Care sector. MSCI Europe Energy Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Energy sector. MSCI Europe Utility Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Utility sector. MSCI Europe Financials Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Financials sector. MSCI Europe Telecommunication Services Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Telecommunication Services sector. MSCI Europe Consumer Discretionary Index: A market capitalization- weighted measure of the performance of companies within the MSCI Europe Index that are in the Consumer Discretionary sector. MSCI Europe Materials Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Materials sector. MSCI Europe Industrials Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Industrials sector. MSCI Europe Consumer Staples Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Consumer Staples sector. MSCI Europe Information Technology Index: A market capitalization-weighted measure of the performance of companies within the MSCI Europe Index that are in the Information Technology sector.
Jeremy Schwartz, Director of Research
As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."
Tripp Zimmerman, Research Analyst
Tripp Zimmerman began at WisdomTree as a Research Analyst in February 2013. He is involved in creating and communicating WisdomTree's thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Prior to joining WisdomTree, Tripp worked for TD Ameritrade as a fixed income specialist. Tripp also worked for Wells Fargo Advisors, TIAA-CREF and Evergreen Investments in various investment related roles. Tripp graduated from The University of North Carolina at Chapel Hill with a dual degree in Economics and Philosophy. Tripp is a holder of the Chartered Financial Analyst designation.
WisdomTree Funds are distributed by ALPS Distributors, Inc.
Jeremy Schwartz and Tripp Zimmerman are registered representatives of ALPS Distributors, Inc.
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