Time To Buy European Equities?

by: Matthew Castel

Despite the recent spate of volatility linked to Greek debt talks, it may be time for the prudent long-term investor to consider increasing exposure to European equities.

The European banking sector is improving, and the recent quarterly earnings season has been largely positive for European companies.

Eurozone profit margins are improving relative to the United States where margin expansion may be slowing.

The market risk of Grexit contagion to the EU appears to be overblown.

Despite the recent spate of volatility linked to Greek debt talks, it may be time for the prudent long-term investor to consider increasing exposure to European equities. Recent weakness in European equities due to a reversal of bond and currency market trends coupled with Grexit fears may constitute a favorable entry point. The case for increasing European equity exposure will be made, the U.S. equity market alternative will be considered, and the market risks of Grexit will be evaluated.

Improving European Fundamentals

Year to date, low government bond yields and a falling euro have been two factors driving the eurozone equity prices, so as these trends unwind, underperformance should not come as a surprise. Nevertheless, these macro factors were not the only factors supporting eurozone equity outperformance. More importantly, the recovery of Europe's banking sector coupled with increasing bank lending to companies remains a key factor. In addition, there have also been encouraging signals from companies themselves.

The recent quarterly earnings season has been largely positive for European companies. Sales and profits have been improving, with robust sales, indicating that profitability gains were not solely based on cost cutting. In addition, contrary to the popular belief, sales growth has not been driven exclusively by a weaker euro, as many companies have reported stronger organic growth linked to stronger underlying demand. Furthermore, the drop in oil prices has not yet filtered through to the European consumer and should support more robust domestic consumption.

Attractive European Profit Margin Expansion Relative to the United States

Also of note are improving eurozone profit margins relative to the United States where margin expansion may be slowing down.

Data from Bloomberg shows the trailing 12-month profit margin for companies listed on Europe's STOXX 600 floats around 5.9%, which is still far off its pre-financial crisis peak of 10.7%. This number is significant as the profit margin for companies listed on the S&P 500 stands at around 8.9%, which is quite close to its pre-financial crisis peak of 9.5%.

From a historical perspective, data from Bloomberg has indicated that the two regions have had similar margins, with an average gap of about 90 basis points over the last ten years. With the gap currently sitting around 300 basis points (3%), there may exist an opportunity.

In addition, just a few days before the start of earnings season, Wall Street forecasters are predicting that U.S. profits will fall 6.5% in the second quarter, the most bearish estimate of this ageing bull market. Thus, even if companies manage to beat these expectations, it will not be enough to lift profits from last year's levels. This is significant as a shrink in profits may not derail America's slow yet steady recovery, but it may dampen demand for the U.S. equities given current valuations.

Market Impact of Grexit Overstated

Over the last few days, major European equity benchmarks have been suffering given the uncertainty wrought by Tsipras's political brinkmanship. What appears to be rattling investors is not so much the inability of Greece to pay back its debt, but rather the contagion effect on the eurozone that a default and potential Grexit would cause. Furthermore, investors are concerned that a Greek exit could set a potentially devastating precedent by casting doubt on the supposed irreversibility of EU membership. Uncertainty has always been the Achilles' heel of the financial markets and thus it would seem that investors exposed to the eurozone have legitimate reasons to be concerned. Nevertheless, data seems to suggest that such fears may be overblown. In a recent note, Jeremy Zhou of FactSet explains that based on a conventional exposure analysis of the MSCI Europe benchmark, it is more than 80% exposed to the EU and 100% exposed to Europe (inner pie chart).

At first blush, investor fears seem to be substantiated as by conventional geographic exposure (assigning a single country exposure to each company based on its country of domicile) Europe dominates. Yet, countries generate revenue internationally, and thus, based on geographic revenues, FactSet has found that MSCI Europe's exposure reveals a different picture. The report found that:

It is no longer 100% exposed to Europe

More than 18% of its aggregate revenue comes from the U.S.

Another 21% comes from Emerging Markets

Only 42% of the exposure comes from the EU (outer pie chart)

Given this marked divergence, the risk of contagion to the EU may be overblown as a Grexit will likely have little to no impact on the economic activity in both the United States and Emerging Markets. Furthermore, if Greece were to descend into greater financial difficulty, its imports constitute roughly less than 1% of the total imports of its largest trading partners Russia, Germany, Italy, Saudi Arabia and China. In addition, the bulk of Greek government risk has been removed from European bank balance sheets onto those of eurozone governments and the ECB. Furthermore, if Grexit caused any marked deterioration in peripheral spreads, the ECB's policy of "whatever it takes" would most likely lead it to intervene aggressively with further stimulus from its QE program.

Taken together, these facts suggest that the current weakness in European equity markets is undeserved. Instead, the prudent long-term investor may be well served to consider the recent volatility in European equity markets to be an attractive entry point rather than the first act of the next European tragedy.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.