Europe to surprise on the upside
Investor sentiment on Europe has turned. Although the long-term challenges affecting Europe have not dissipated, BlackRock chief investment strategist, Russ Koesterich1, sees relative value in European equities, particularly the cyclical names which stand to benefit the most from a stabilising economy and a "risk-on" regime.
If, as expected, the euro continues to depreciate against the US dollar, European equities are also likely to benefit from higher exports. This is an important consideration given that 50 per cent of revenue for European large-cap companies comes from outside the Eurozone.
Nevertheless, the Eurozone remains buffeted by opposing forces. On the positive side, short-term economic indicators have turned higher and quantitative easing (QE) has finally been introduced. However, a host of issues have yet to be confronted, let alone solved: structural impediments to growth, dangerously low inflation, and rising populism following five years of little growth and painful austerity.
Despite these challenges, on both the anticipation of, and in reaction to, the European Central Bank's (ECB) QE announcement, investors have bid up European stocks. It appears that most investors are buying into the idea that the US Federal Reserve's (the Fed) various incarnations of its own QE program over recent years were at least partly responsible for the market gains there over the past several years.
Benefit of the doubt
Whether you attribute the newfound appetite for risk to QE or simply the realisation that things are not quite as bad as some thought, for now investors are willing to give Europe the benefit of the doubt.
And why not? While the evidence for QE's impact on multiples is largely anecdotal, there is another mechanism by which the European version of QE is likely to help equity markets: a cheaper currency.
Since mid-2014 the euro has weakened by nearly 20 per cent against the US dollar. A weaker euro is not simply a function of looser monetary policy from the ECB, but also impacted by the end of QE by the Fed.
The divergence in monetary policy between the two regions, which we expect to continue, has resulted in a big boost to European exporters, particularly automakers and industrial companies.
It may be that Europe's economy is turning a corner and, if so, substantial ECB QE should support stocks.
Even within the more troubled southern economies, there are a few bright spots. Spain has gone through a period of painful structural reforms, which now appear to be bearing fruit. Spanish unit labour costs have fallen and the country is now running a consistent current account surplus. As a result, Spain is likely to grow by more than two per cent this year - one of Europe's strongest growth rates.
At the same time we are also witnessing something of a rebound in Europe's largest economy, Germany.
Despite the negative impact the Russian sanctions are having on German manufacturing, most business surveys in Germany have turned higher, as have the purchasing managers indexes (PMI).
Historically, these metrics have been correlated with both coincident and forward German gross domestic product, suggesting better growth ahead.
The recent stabilisation in Europe's economy is also a function of a few unrelated developments: lower oil prices, a modest rise in credit growth, and a slow improvement in the competitiveness of many of the peripheral countries, for starters.
As is the case in the US, lower oil is pro-cyclical for Europe and supports stronger household consumption.
At the same time, we are finally starting to see some turn in the European credit cycle.
A recent lending survey by ECB demonstrated a significant increase in the demand for loans and credit lines. After a long drought, European businesses are starting to borrow again.
There are also longer-term factors that are helping to drive the recovery. Part of the recent improvement, particularly in Spain, can be attributed to a marginal improvement in competitiveness.
After many years of frozen or falling wages, European labour costs are falling, both in absolute terms and also relative to Germany.
On the other hand, there is still significant concern around Greece, with the country needing to agree with its creditors on a list of reforms by the end of April.
In the UK, the forthcoming general election in May is contributing to political uncertainty, with the most recent opinion polls suggesting a weak coalition government, which is unlikely to calm markets.
A Labour government would be tougher on business, and might be seen as lacking fiscal credibility, while a Conservatives-led cabinet could signal an unsettling referendum on the UK's European Union membership in 2017. Sterling and UK equities could take a temporary hit as the next government introduces austerity measures.
The case for Europe
But while, generally speaking, the pessimists appear to be wrong, for now, a modest improvement in an otherwise unresponsive growth rate is not by itself a sufficient reason to overweight European stocks.
Instead, the case for European equities revolves around two key themes.
The first, as mentioned earlier, is that investors seem to be placing much of their faith in the ECB, much as they did with the Fed in 2012 to 2014. QE also mitigates the risk of full-blown European deflation.
Given the plunge in realised inflation over the past six months, this is an important consideration.
Whether you attribute the newfound appetite for risk to QE or simply the realisation that things are not quite as bad as some thought, for now investors are willing to give Europe the benefit of the doubt.
The combination of anaemic aggregate demand and a collapse in oil prices has pushed European inflation deep into negative territory.
Inflation is now -0.6 per cent, and even lower in several peripheral countries. While the recent stabilisation in oil prices should help by year's end, there is little doubt that low European inflation is more than just a function of lower energy prices.
Given sluggish demand, falling real wages and deteriorating demographics, Europe is at risk of a more malign and prolonged bout of deflation. The ECB's recent action should help to alleviate this risk.
This is important not only for revenue growth, itself a function of pricing power, but also for equity multiples. Historically, equity multiples have been highest when inflation is low, but not too low. To the extent that QE enables the Eurozone to achieve low, rather than negative inflation, this will be a supportive environment for stocks.
The second factor is that while not an absolute bargain, European equities are reasonably priced relative to the increasingly stretched US stock market.
On several metrics, including cyclically-adjusted price-to-earnings, European equities are trading at a significant discount to US equities. While slower growth, low inflation and the lingering geopolitical risks associated with Greece and Russia argue for some discount, the current one may be exaggerated.
Based on the past year's price-to-book ratio, European equities are trading at a multiple of roughly 1.5 times book value, which is a 10 per cent discount to the 15-year average.
In contrast, US equities are trading at roughly 2.8 times book value, which is a 10 per cent premium to their long-term average.
As a result of this divergence in valuations, European stocks are trading at a 45 per cent discount to the US.
While the discount was even larger back during the height of the euro crisis, the current discount compares favourably with the long-term average of around 35 per cent.
How to invest in Europe
There are a number of different ways that Australian investors and their advisers can gain access to opportunities in Europe.
There is the option of investing directly in companies listed on European stock markets, although the drawbacks to this direct investing approach include expense considerations and portfolio concentration versus diversification trade-offs.
While managed funds offering international and European exposures will do the job, an efficient and cost effective way to ensure a diversified, benchmark exposure to Europe is with exchange traded funds (ETFs).
In contrast to a direct investment in a single company, an ETF provides exposure to the securities underlying the particular index the fund seeks to track. ETFs provide Australian investors with what can be an efficient way of gaining access to international markets.
As each ETF is passively managed and designed to follow a particular underlying index, the expense of managing an ETF is generally lower than that of actively managed investment funds. This cost saving is passed onto the end investor.
Finally, unlike unlisted managed funds and unit trusts, which permit trades (buy/sell) to be processed only at a closing price, ETFs can provide much greater trading flexibility as they are listed on the ASX and can trade throughout the entire trading day.
Jonathan Howie is the head of iShares Australia at BlackRock.
Footnote
1. KOESTERICH, RUSS. March 2015. "Europe Rebounds? The Opportunities and Risks in the Eurozone."
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