05 May 2015

Despite Challenges: European Equities Present Buying Opportunities

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Despite Challenges, European Equities Present Buying Opportunities
by Juliet Cohn, Portfolio Manager

Since the beginning of 2014, the European economy has been under an umbrella of a sluggish macroeconomic environment. Even with some recent economic data doing very little to wash away the gloom and doom, the forecast may be calling for sunnier days on the horizon for European equities.

Indeed, growth in Europe has been anemic, and growth expectations have been relatively weak. The European region has lagged other regions such as the United States where companies have recovered more quickly in the aftermath of the global financial crisis. Profit margins in the United States, for example, have bounced back and continue to be on the upswing, while those in Europe have rebounded at a slower pace and are still below their pre-financial crisis peaks.

With valuations and expectations relatively low, we believe European equities present a buying opportunity for investors and continue to look attractive compared to other regional developed equity markets and other asset classes. Valuations are hardly stretched, with the 12-month forward price-to earnings ratio of the MSCI Europe Index at about 14.8x. Net U.S. buying of European equities has recently turned positive and we have seen some nice flows to the region, but it is not overbought by historical measures.


There remain risks to investing in Europe – perhaps the most worrisome is “political” risk. Geopolitical concern over Russia’s annexation of Crimea, its military intervention in Ukraine, and what Russian President Vladimir Putin’s intentions for Ukraine (and other former Soviet republics) have been particularly worrisome for the region. Several other European countries are facing elections and many
have favored anti-austerity political parties.

We have seen the extreme Syriza party elected in Greece, and while they have toned down some of their rhetoric to get elected, they remain a risk. Syriza has committed to “rolling back” austerity, and yet do not have the means to do so. The majority of Greeks want to remain in the European Union (EU) and continue to use the euro, so they are constrained in what they can do. However, the risk of a disorderly Greek exit from the Eurozone has risen, not least to the inexperience of the new government there, who are still testing just how much the European Commission will yield. Valuably, the EU has had several years to prepare for a Greek exit and have been able to establish firewalls that could help ensure it would not be the disaster that it likely would have been five years ago. While it still remains certainly conceivable to see Greece leave the Eurozone without a breakup of the euro, we believe this is unlikely given the political will surrounding the euro’s survival.

Political parties in other European countries are watching closely what happens in Greece. In Spain, the Podemos party is talking of nationalization of strategic sectors (such as electricity, energy and telecommunications) and curtailing the power of the EU. In Germany, the Alternative for Germany party is gaining in polls, and similarly the Eurosceptic Freedom Party is gaining in Holland. It is worrying to see young people attracted to these parties – especially since they are the ones suffering the most with unemployment. 

Unemployment across Europe has been an ongoing concern (and already factored into to stock prices). With regards to unemployment in Europe, things are now so bad they can only get better. While the current unemployment rates in the United States, the UK, Japan, and even many emerging markets have fallen below their 10-year average, it has remained stubbornly high in the Eurozone at 11.2%. So, any sustainable recovery in employment in these other countries would be at the expense of corporate margins – except in the Eurozone.


Despite these challenges, the outlook for European equities is bright(er). Macroeconomic fundamentals are improving thanks to lower input prices; a weaker euro that should start filtering into corporate earnings over the next couple of quarters; and the European Central Bank delivering quantitative easing. Euro area surprise indicators have risen to a two-year high, boding well for future growth. In fact, 60% of European companies are beating sales estimates, the best level it has been for two years. With extra cash on their books, European companies have, on average, been paying dividends yields of almost 3%, pretty attractive compared to fixed-income yields by today’s standards!

Another factor benefiting European companies is the sharp decline in oil prices. 85% of global GDP is generated in countries that are net importers of oil. This is worth noting because, in Europe, only Norway is an exporter of oil, while the rest of Europe is a net importer. With the price of oil falling by more than half from its level in June 2014, the region is set to benefit. 

European companies have become adept at seeking out growth where they can find it since domestic growth and consumer spending has tended to be so sluggish. For example, before growth began to slow in emerging markets (EM), listed European companies generated 34% of their revenues in EM countries. Once EM growth began to cool, European companies re-focused their attention to North America and Asia for revenue growth. Today, European companies are now generating 54% of their revenues from outside the developed Europe region.

Again, we believe European equities present a buying opportunity for investors and continue to look attractive compared to other regional developed equity markets and other asset classes. Growth is beginning to accelerate in Europe. The EMU composite PMI is up 2.2% over the last three months, surprising financial markets positively. We believe this is likely to continue since the ECB has taken further measures to ease credit conditions, buoying consumption growth. The 18% fall in the euro versus the U.S. dollar in the last six months will have a very real impact on European companies’ competitiveness and earnings in general, and will serve to further support growth trends for European companies.



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