In a mid-February address in front of the European Parliament, ECB President Mario Draghi highlighted both the progress of the Eurozone's economic recovery as well as the evolving challenges still confronting the region, particularly as it relates to mounting concerns over emerging market economies and broader geopolitical risks. In his speech, however, Draghi helped eliminate one of the big question marks facing investors in the region when he affirmed unequivocally that the European Central Bank "will not hesitate to act" if required to help put the euro-area economy on still firmer ground. This, in addition to other catalysts, is among the key factors driving optimism around European equities, as the region could provide one of the more attractive destinations for investors over the next 12 to 18 months.
As most marketwatchers are well aware, the economic travails in Europe in the years following the 2008 financial crisis left many investors in the region with white knuckles and lingering suspicions around the durability of any recovery. But today, some 18 months after the U.S. economy has stabilized, it's becoming evident that European business and economic cycles have finally established a foundation from which more growth will likely come.
With an improving macro-economic picture and Mario Draghi affirming his commitment to maintain an accommodative monetary policy, investors in the region can still benefit from valuations that on a relative basis reflect the region's plodding, indirect path to recovery as opposed to the improving opportunity set now materializing. And while renewed global economic unrest and market volatility may give pause to investors still battle worn from the region, we believe the improving macro picture, the ECB's ongoing commitment to stimulus, and the attractive valuations, together, make Continental Europe one of the more compelling areas for investors seeking returns amid a volatile global environment.
In a lot of ways, the opportunity for equities in Continental Europe resembles a coiled spring. The double-dip recession served to defer the start of the region's economic cycle, but with real GDP growth now beginning to accelerate, the gap between the euro area and the rest of the world is quickly closing (see charts, below).
And while the OECD recently lowered its global growth forecasts, it still projects the Eurozone economy to expand by 1.4% and 1.7% in 2016 and 2017, respectively.
Even as the macro picture doesn't necessarily signal the likelihood for rapid growth, the transition to more consistent and steady expansion will lend itself to improved performance at the corporate level. As companies in the region have focused on cost-cutting initiatives over the previous seven years, the transition back to a growing economy means a large proportion of these businesses are well positioned to increase revenue and earnings and improve margins. Moreover, even as the banking sector in Europe remains an area of concern, bank balance sheets have improved and significant reforms have been implemented, which together have translated into a more robust capital markets environment with available capital to support business expansion. Coupled with GDP growth, the added liquidity is a critical catalyst as most key sectors in Europe seek to resume a growth trajectory.
According to S&P Investment Advisory Services, eight out of 10 sectors from the Euro 350 are expected to show significant earnings growth in 2016. Of the eight sectors expected to grow profits, seven are pegged to show double-digit increases this year, led by Technology, Consumer Discretionary and Financials. Only the Energy and Materials sectors are currently projected to show year-over-year profit declines.
Incoming Wave of Liquidity
While the European Central Bank was slower to respond than the United States Federal Reserve coming out of the financial crisis, since 2014 the ECB has made up for lost time. In June 2014, the ECB pushed the deposit rate into negative territory, while subsequent interest rate cuts have left the deposit rate at negative 0.4 percent, the most recent cut coming in the second week of March. The ECB also enacted its version of quantitative easing at the start of 2015 and alongside its March interest rate cut, also boosted its bond-buying program from €60 billion a month to €80 billion and made euro-denominated non-bank corporate bonds eligible for the first time.
These efforts have had a positive effect, reflected in both economic growth as well as a gradual recovery in credit conditions. In 2015, loans to both non-financial corporations and households showed material increases. (See charts, below.)
For those parsing the minutes from the ECB's February monetary policy meeting, it was clear that the European Central Bank remains intent on using all means necessary to ensure the recovery stays on track. The ECB, four separate times, underscored that it expected policy rates to remain at current or lower levels for an extended period of time, and reinforced that policy makers were reviewing the technical conditions to ensure "the full range of policy options" would be available if needed. And when the ECB met again in March, it followed through with a 10 basis point cut and the expansion of its QE program. In its decision to include corporate bonds in the QE program, the minutes released in April reveal that the ECB premised the move on an anticipated spillover effect for small and medium-sized enterprises.
The renewed urgency from the ECB stems from worries over weak energy prices that while positive to household income and corporate profits, are also helping to frame an uncertain backdrop along with skittishness over emerging market growth and renewed geopolitical tensions. Since the ECB's December 3 policy announcement, the STOXX 600 index had lost as much as 15% leading up to Mario Draghi's comments in front of the European Parliament in mid February. But as an intermediate-term play, these near-term worries overshadow the fact that on a historical basis, the stock market capitalization of European equities remains near its nadir.
Going back to 2009, the S&P 500 has significantly outperformed the STOXX 600, and European equities today remain far less expensive than US stocks. This is true on both an absolute and relative basis, using a cyclically adjusted price-to-earnings ratio. (See charts, below.)
Moreover, as of March 31, 2016, the forward-looking price-to-earnings ratio of 15.2x for the STOXX 600 index remains below the index's long-term average. When coupled with the consensus expectation of an 11.5% increase in earnings, the upside potential to investors in Europe is clear.
From the perspective of fund investors, the opportunity set can perhaps be best realized through pure exposure to Continental Europe, excluding the United Kingdom, whose equity markets, today, more closely resemble US stocks on a valuation basis. We also see Europe as a beta play, as current valuations and the ECB's commitment to stimulus provides a floor for investors offering downside protection, whereas the potential for alpha, via stock selection through actively managed funds, is somewhat muted given the efficiency of the large-cap segment in the region.
Of course, those familiar with Europe understand too that several unknowns still weigh on equities. Ongoing efforts to fix the European banking system, which has moved in fits and starts, remain critical to future growth, and marketwatchers already understand that Europe has considerably more exposure to China than U.S. equities. These are two of the primary drivers behind the volatility witnessed at the close of 2015 and into 2016. Not to be overlooked, the left-leaning Socialist movements are another cause for concern, especially as the market witnessed what can happen when the Greece debt crisis unfolded last year, necessitating a third bailout agreement. Today, the biggest unknown facing European equities is around a potential "Brexit" and whether or not UK voters will opt to stay in the European Union. Should voters decide to depart the EU, Britain's exit would have significant spillover across the continent. On top of all of this, investors have to contend with the "unknown" unknowns, be it terrorism, world affairs or other unforeseen, black swan events.
All that being said, over the intermediate term few regions in the world today can match the catalysts currently favoring European equities - benefiting from the improving macro environment, the ECB's commitment to stimulus and historically attractive valuations. Even as the near-term promises more noise and the long-term may see valuations level off, over the intermediate term, continental Europe represents one of the more attractive destinations for investors in a market suddenly devoid of obvious alternatives.
Michael A. Mullaney is a Vice President and Chief Investment Officer in the Boston office of Fiduciary Trust Company (fiduciary-trust.com), having joined the firm 15 years ago.
Disclosure: The opinions expressed in this publication are as of the date issued and subject to change at any time. The materials discuss general market conditions and trends and should not be construed as investment advice. Any reference to specific securities are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Nothing contained herein is intended to constitute legal, tax or accounting advice and clients should discuss any proposed arrangement or transaction with their legal or tax advisors.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The opinions expressed in this publication are as of the date issued and subject to change at any time. The materials discuss general market conditions and trends and should not be construed as investment advice. Any reference to specific securities are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Nothing contained herein is intended to constitute legal, tax or accounting advice and clients should discuss any proposed arrangement or transaction with their legal or tax advisors.