European markets have performed poorly in the past year, losing 13.5 per cent in euro terms. The cause of market volatility in the recent past has tended to come from within Europe, with the stability of the European Union often being called into question.
In the past year, however, Europe has moved away from centre stage, with the drawdown driven by concerns in other areas of the world, to which Europe has significant exposure through its large multinational corporates.
These concerns include the US being close to a recession, the impact of a falling oil price on growth, and China’s foreign exchange policy. Europe has not been absent entirely, with the market also worried about the impact of negative interest rates on banks’ profitability and by extension on the wider economy.
Starting with the economic backdrop, our view is one of an extended period of low growth, low inflation and low interest rates, rather than outright recession. This is because the global economy continues to suffer from overcapacity in many industries (especially in many emerging economies), as well as the mountain of debt that has built globally (now standing at 245 per cent of GDP including public and private debt).
Near term, several regions are actually experiencing a small acceleration in growth, partly as the drag from the investment slowdown caused by the falling oil price eases.
Europe has suffered less from this because of the absence of significant oil production, allowing for more consistent growth, led by consumer spending which has been boosted by the lower oil price.
While the overhang of debt on growth will remain for the foreseeable future, this also creates a safety net for growth and asset markets as it means central banks should remain accommodative, as seen most recently in Europe through the additional easing measures taken by the European Central Bank (ECB).
China remains a concern to investors; fears of an economic hard landing have subsided only to be replaced by concerns around currency devaluation and its impact on other emerging markets.
However, the yuan has recently shown more stability, while emerging market currencies such as the Brazilian real and Indonesian rupiah have rallied sharply since the February lows.
The reality remains that China is an economy in transition from fixed asset investment towards consumption. Economic data supports this with retail sales and new car registrations continuing to grow strongly.
The continued poor performance of banking stocks in Europe along with the commitment of the ECB’s president, Mario Draghi, to negative interest rates, has led many to question whether the region’s growth could be affected by a lack of loan availability.
However, the reality is that the region is over-geared on many levels and actually needs to deleverage. Loan growth has not been a feature of the formative years of economic recovery in Europe and as such, there is no reason why a tightening of financial conditions should cause any undue hindrance.
Asset markets are discounting mechanisms and can quickly move to price in the economic backdrop. While this is somewhat subjective and therefore difficult to ultimately demonstrate, many of these headwinds have been widely discussed across the investment community suggesting that at least some of these have already been discounted.
Should the worst case around the economy and some of the other issues fail to materialise, the market could quickly move to focus on the merits of the asset class. One of these is valuation, with Europe now trading on 15x price to earnings, in line with its longer-term average.
Valuation looks even more relative to other asset classes, with close to half of European government debt now trading with a negative yield, and European investment grade bonds yielding 1.3 per cent versus a healthy 3.8 per cent dividend yield from European equities.
At a sector level, consumer staples and discretionary sectors look attractive as they are well positioned to deliver growth, with drivers such as low product penetration in emerging economies and the positive impact from the lower oil price.
Another area is the telecoms sector, with data usage growing between 70 and 100 per cent per year across Europe. This, combined with tighter network capacity, has led to price rises in the sector for the first time in several years.
However, certain industries, such as banking and utilities, continue to face structural challenges. Stock and sector selection therefore remain as important as ever, with our current preference being towards high-quality businesses that are positioned to be able to deliver profit growth in a low growth economic environment.
Rajesh Tanna is a senior portfolio manager at JP Morgan Private Bank
