Institutional Perspectives

Key Takeaways

• European equities represent a compelling opportunity given their relatively low valuation and improving economic fundamentals on the continent.
• GDP growth, lending and inflation have been rising in Europe as the ECB remains accommodative.
• Despite election fears, economic drivers and earnings growth will determine market returns in Europe in 2017 and 2018.

European equities have been at relatively low historic valuations compared to U.S. stocks for some time. Concerns that upcoming elections on the continent could usher in far-right populist leaders who would seek to leave the European Union (EU) have not helped market returns. But even as some investors focus on another year of political risk in Europe, we feel strongly that the potential for more robust earnings growth – led by positive economic indicators, ongoing accommodative monetary policy from the European Central Bank (ECB) and beneficial currency translation effects – make underappreciated European growth stocks a powerful proposition for long-term investors.

Electoral uncertainty has made many investors wary about allocating capital to the eurozone, as added risk premia have resulted in valuation weakness among European equities relative to the U.S. For example, the Bloomberg 2017 calendar year price-to-earnings (P/E) ratio estimate for the S&P 500 as of February 28 was 18.3x. But the calendar year P/E ratio estimates of the MSCI country indices for France, Germany, Spain and Italy were a relatively low 14.6x, 13.9x, 13.2x and 12.6x, respectively. European growth stocks are also undervalued relative to U.S. equities. The 2017 calendar year P/E ratio for the MSCI Europe Growth Index was 17.4x, compared to 20.2x for the Russell 1000 Growth Index.

There is perhaps some reason to worry about upcoming elections and other political developments. Three of the six founding EU countries (the Netherlands, France and Germany) will go to the polls this year to elect new leaders. A fourth, Italy, could call snap elections sometime in the summer. Meanwhile, the United Kingdom continues to march toward an exit from the EU, and an ongoing debt crisis in Greece could require a new bailout. Sustained political risk could endanger economic growth and corporate earnings for some time. However, we do not foresee additional exits from the EU or eurozone as a result of these elections. Every time there has been a crisis in Europe over the past seven years, European leaders eventually found the resolve to continue moving forward toward greater integration.

"We view France as a microcosm of the EU, where the perceived risk is much higher than the actual risk."

Furthermore, it’s not all that clear that anti-EU leaders will be able to win in upcoming elections. The first vote will be in the Netherlands on March 15. The polls there show a tight race for a plurality of seats in Parliament between the anti-immigration Party for Freedom, led by Geert Wilders, and the liberal People’s Party for Freedom and Democracy. Both parties are expected to fall short of a majority in Parliament, so even if Wilders’ party wins – undoubtedly a negative result for European integration – it would still need to form a coalition with a more pro-EU party to govern.

In France, National Front candidate Marine LePen is very unlikely to win either a majority in parliament or a runoff election against centrist challenger Emmanuel Macron, who edges her by roughly a 60-40 margin in recent polling. And in the event she does manage to win both rounds of the presidential election, LePen would face the reality that most in the French Parliament would be hostile to her far-right ideas. We view France as a microcosm of the EU, where the perceived risk is much higher than the actual risk. Once investors realize this, French and European equities should re-rate upward.

And finally, Germany may face a change in leadership from the steady hand of Angela Merkel to left-leaning Martin Schulz. But while this might result in some changes to economic policy within Germany, Schulz and his Social Democratic Party have been wholly supportive of the European experiment and wouldn’t be likely to harm eurozone economic stability.

 

Exhibit 1: U.S. and Eurozone GDP Trend Since 2007 (Indexed to 100 in 2007)

For the purposes of analysis, we indexed U.S. and eurozone GDP to 100 at the beginning of 2007 to compare relative GDP growth over time. Sources: U.S. Bureau of Economic Analysis, Statistical Office of the European Communities. As of Dec. 31, 2016. 

Ultimately, we believe these political risks will fail to dampen what is already becoming clear – Europe is on the right path for a broad recovery. Most economic indicators are pointing in the right direction, and the European Commission is forecasting growth for every EU economy in 2017 and 2018 for the first time since 2008.¹ Combined with broader global economic growth, it’s likely that European economies will see stronger earnings growth over the remainder of 2017 and 2018 – a positive development for investors in European equities.

It’s fair to say that the ECB deserves some credit for improving conditions. The central bank’s unprecedented asset purchasing program, announced in early 2015, has supported broader growth, an expansion in bank lending and a positive turn in inflation. Exhibit 1 shows the trajectory of real GDP for the U.S. and eurozone, indexed to 100 in the first quarter of 2007. While 10-year eurozone economic performance has been lackluster compared to the U.S., GDP has been on a steady upward path since 2013, with slightly stronger growth from the fourth quarter of 2014 onward.

 

Exhibit 2: Growth in Fed and ECB Assets as a % of GDP (Indexed to 0 in 2008)

This graph shows the growth in Federal Reserve and ECB assets as a percentage of GDP indexed to 0 in 2008. What stands out is that the ECB's bond buying fell after 2012, but has ramped up dramatically since ECB President Mario Draghi announced its most recent asset purchase program in early 2015. The ECB's balance sheet as a percentage of GDP is now larger than the Fed's, and is expected to remain larger for the foreseeable future. Sources: U.S. Bureau of Economic Analysis, U.S. Federal Reserve Board, Statistical Office of the European Communities, European Central Bank. As of Dec. 31, 2016. 

Moreover, belief that the ECB will continue its accommodative monetary policy for the foreseeable future (likely until the end of 2017 or early 2018) has provided broader market confidence. The ECB’s actions, particularly since 2015 (see Exhibit 2), have kept interest rates low and helped to stimulate more lending activity. As Exhibit 3 shows, net flows of bank loans to non-financial corporations and households were negative from 2012-2014, but began to shift into positive territory in 2015, coinciding with the ECB’s new asset purchasing program. While lending to businesses and individuals has yet to recover to pre-financial crisis levels, one could argue that banks were excessively lending in the lead-up to the crisis anyway, and that a more realistic level to achieve might be 2004, when lending began recovering from the 2003 recession. In that sense, bank loans to businesses and households still have room to grow, but the trend is encouraging.

 

Exhibit 3: Eurozone Net Flow of Bank Loans to Households and Non-Financial Corporations

Source: European Central Bank. As of Dec. 31, 2016. 

Consumers are also feeling more positive about the economy, as eurozone economic sentiment has improved to 2011 levels.² This shows that ECB stimulus may be working to build demand, generate growth in lending and improve economic activity, leading to expectations that prices should rise in the coming year, ending deflationary fears permeating the market. Year-over-year headline inflation had already increased to 1.63% in January 2017, from 1.14% in December 2016.³ And most estimates of core inflation, which excludes energy and food, show a steady increase for the remainder of 2017 and into next year.

Politics, while important, are transitory and generate a lot of noise, making it more important to focus on the true driver of market performance over the long term – earnings growth. Low valuations, like we see now, also provide plenty of upside for investors. With persistent negative interest rates and weak economic growth, earnings and valuations in Europe have been depressed for some time, particularly among stocks in the financial sector – the largest sector by weight in the MSCI Europe Index.⁴ But positive economic data both inside and outside Europe points to an improving environment for corporate earnings; and we believe European equities may be at an inflection point.

Perhaps the most important driver of earnings growth on the continent, and thus longer term market performance, is the benefit an undervalued currency can provide European companies. European companies generate nearly 50% of their revenues abroad, according to MSCI.⁵ With the euro at historic lows relative to the dollar, and given expectations for stronger U.S. and global economies over the next few years, we may begin to see a boost in top-line numbers from overseas customers due to competitive pricing and positive currency translation effects. Ultimately, this should support more robust earnings growth for European equities. The market sees this potential as well, with earnings growth for the Eurostoxx 50 expected to be roughly 8.6% in fiscal year 2017 and 10.1% in fiscal year 2018, according to data from Bloomberg. Similar improvements are expected across country-specific equity indices.

Currency could also play an important role in driving returns for investors in Europe. While currency risks can never be eliminated, we don’t foresee the euro falling much below its current level; and, barring a sudden shift in ECB policy, we don’t foresee the euro rising rapidly either. If economic growth improves as expected, the ECB will likely begin to taper and ultimately end its asset purchasing program sometime in early 2018. This should, in turn, push the long-dated portion of the yield curve up and serve to strengthen the euro over the long term. Thus, even as euro-based equity returns rise, U.S.-based investors in Europe, for example, would likely also benefit from a rising currency, as the dollar value of their European equities increases as well.

Our overall thesis of a Europe poised for a stronger recovery that should support equities going forward isn’t impaired by perceived electoral uncertainty. Perceived risk in Europe is much higher than the actual risk of a eurozone break-up, which many investors seem to believe is more likely than not. This has led to relatively low valuations for European equities, which should re-rate upward once exaggerated political risks fade and investors begin to realize that economic fundamentals and corporate earnings growth are improving.