Emmanuel Macron’s victory at the French presidential election has removed some of the political risk and uncertainty around Europe.
This outcome will certainly improve sentiment towards the region. Until now, a succession of elections in Europe has kept investors on the sidelines as fundamentals have been overshadowed by political risks. Going forward we expect positive economics and earnings to drive increased investor interest in Europe.
Global fund managers are now revealing an overweight positioning in euro-zone equities compared to past history, according to the BofA Merrill Lynch Global Fund Manager survey in March. However, while we have seen some fund flows into European equities year-to-date, these have only partly made back the huge outflows seen in 2016 (about US$98 billion, according to the Boston fund manager EPFR). In the short term, some technical indicators show European stocks being overbought and, in fact, we witnessed some profit taking after the French election. Over the medium term, the ability for profit margins to normalise is key to the argument that European equities look cheap relative to history and have the potential to rerate.
European fundamentals have meaningfully improved. The latest euro-zone purchasing managers index (PMI) has been revised to 56.8, the highest in the past six years. Consumer and business confidence are both at 10-year highs, while car sales and construction growth have been accelerating. In addition, European companies are benefiting from global growth, with more than 50 per cent of European revenues coming from outside the region, as well as from currency weakness. While year-to-date the euro has risen, the depreciation seen last year has been visible in this year’s sales and profits. At present, Europe is in a sweet spot as corporations are benefiting from ultra-low funding rates and consumers with high disposable incomes as mortgage rates are at extremely low levels.
However, a change in course of the European Central Bank’s (ECB) monetary policy and the potential for higher rates is a risk to be aware of.
For the past seven years, there has been a large gap between United States and European earnings growth, with the latter significantly lagging behind. Positive fundamentals are now translating into earnings growth. With about 71 per cent of European companies having reported first-quarter earnings, 67 per cent are beating estimates, delivering on average 24 per cent year-on-year earnings growth (as of May 10). These numbers seem to support consensus estimates for full year 2017 earnings growth of 14 per cent.
In terms of valuations, if one looks at price to forward earnings (P/E), Europe is trading at around a 15 per cent discount versus the US – the largest difference since 2012. More broadly, valuations are also attractive versus global equities.
While there are several events to watch out for in the coming months, among which are the general election in the United Kingdom, legislative elections in France, German elections later in the year, and potential elections in Italy.
The ECB meeting in June is also likely to take centre stage. Improving economic trends could lead the ECB to review its assessment of future growth and inflation. Growth is picking up and there are signs of inflation rebounding, although there are strong differences between the core and the periphery.
As such, one can expect the current accommodative policy stance to continue for some time. Monetary policy has undoubtedly helped asset prices and supported economic growth. The future path of policy continues to be a key factor; a rapid increase in rates would hurt both corporations and consumers.
As macro and politics become less dominant in driving equity markets, the environment for active management is turning more positive. This year, on the back of an improving economic outlook, cyclicals have been driving first-quarter earnings growth.
Decreasing correlations reveal greater differentiation among sectors and stocks. This, paired with a renewed focus on company fundamentals, is creating alpha opportunities for stock pickers.
A failure of margins and earnings to recover to pre-crisis levels has resulted in significant underperformance versus US equities and global investors to largely be underweight on the region.
From the end of 2010 to the end of 2016, European markets underperformed US ones by about 100 per cent cumulative in euro terms. While year-to-date European equities are up 10 per cent, positive fundamentals and strong earnings should be supportive of further growth going forward.
Ilaria Calabresi is a vice president at JP Morgan Private Bank.
business@thenational.ae
Follow The National's Business section on Twitter
