European markets surged in 2017 on the back of stronger-than-expected growth, and at the start of this year, market sentiment was extremely bullish in anticipation of a repeat performance. However, in 2018, it’s as if someone flipped a switch and the data has gone in the opposite direction. A stronger euro, increasing trade frictions and a fraught political scene—including an unexpected coalition challenge to German Chancellor Angela Merkel and a bitter Brexit battle in Britain that threatens the leadership of British Prime Minster Theresa May—have rocked confidence, while weaker growth in emerging markets, which buy 30% of all European goods, hurt exports.
We believe Europe will still grow this year, but in a moderately disappointing way compared to 2017. Our current forecasts for the region are 2.2% annual GDP growth for 2018 vs. 3.8% for the US. However, the risks are more likely to the downside given the headwinds facing the region.
A common refrain amongst commentators is that Europe looks attractive due to valuations, and relative to US equities and bond yields, that is a true statement in our view. The challenge is that attractive European relative valuations are often the case, and there has not been a consistent catalyst to see that valuation discount realized. Broadly speaking from an asset allocation view, we have been positioned for several months to be underweight European equities and overweight the US. However, despite this high level positioning, European investment opportunities exist as you dig deeper into the markets. Below are three ways investors can seek opportunities arising from the upheaval in the region.
Investment opportunity #1: Stock-picking
Illustrated in the chart below, European valuations on a price/book (P/B) basis are looking attractive, in our view. As noted above, not only do they look cheap relative to their historical averages, but they also look cheap relative to the US. This may be the biggest gap between P/B measures in Europe and the US in 45 years. Over the last five years, Europe has lagged the S&P 500® Index by 50%, and by 6% since the start of 2018. This is because the return on equity (ROE) for European companies is 700 basis points lower on average than for US companies. This gap needs to close for European valuations to catch up with those of the US.
While these headwinds may dampen the near term outlook, it does create a potential opportunity longer term. Our quantitative measures show bottom-up sentiment toward European stocks is rebounding strongly, though the chart below shows it still lags the US. Our sentiment score captures analyst biases such as upward revisions of earnings as well as other sentiment indicators. It reflects consensus growth forecasts as of the end of the second quarter for European earnings of 8.3% this year, down from 9.5% at the start of 2018. US companies are expected to grow their earnings by 19.7% vs. 10% at the beginning of the year.1
There remains plenty of room for further recovery in Europe compared to the US. Earnings in France and Switzerland remain 5% to 15% below where they were in 2007, while Italy and Spain are 30% to 50% below.
Despite lower European share prices in recent months, earnings per share numbers have continued to rise. This trend suggests a disconnect between the positive outlook for corporate earnings and temporary stock market volatility driven by confounded expectations and the political uncertainty outlined above. As second-quarter earnings figures come in, this disconnect may start to fade, and markets revert to assessing fundamentals. However, given political risks and euro strength, our active quant equity team has an overall underweight to the UK and Eurozone in our European funds, and an overweight to countries such as Switzerland and Denmark.
Investment opportunity #2: Small caps
We are finding select opportunities within European small caps, even though they have outperformed their large-cap peers for an extended period. Since 2009, the Sharpe Ratio of the MSCI Europe Small Cap Index has been more than double that of the MSCI Europe (0.83 vs. 0.38). This means small caps have returned more with the same amount of volatility. Stronger earnings have driven this small caps outperformance. Below, we see that earnings per share growth for small caps is forecast to outpace large-cap growth on average by 2% over the next 3-5 years, which should support further outperformance.
Small caps are less exposed to international trade tensions and global geopolitical risks. The median revenue exposure to the US is just 2% for small caps compared to 13% for large caps.2 This reduced exposure should act as a shelter in the face of escalating trade tensions between the EU and US and also aid outperformance. Additionally, since the premium between European small and large caps has a long-run correlation of 1% to the trade-weighted euro, we don’t see the recent weakening of the euro impacting directly on our positive view on selective European small caps.
Risks to small caps come chiefly from competition and financing, so they are more sensitive to higher interest rates. Given that we are in an era of tightening monetary policy, this remains something to watch for alongside any significant slowdown in the economic data.
Investment opportunity #3: Sectors
In these more volatile markets, investors may wish to consider positioning their portfolios more defensively, but finding the right sort of defensive exposure in Europe is crucial.
Traditionally defensive sectors such as telecoms and consumer staples no longer offer the same sort of protection when volatility spikes. Telecoms face structural challenges such as long-term price competition and are capital-intensive. Consumer staples, meanwhile, are struggling to grow revenues and are very focused on cost-cutting.
Our fundamental equity team is finding opportunities in the energy and financials sectors. Energy in Europe is twice as important in size terms for markets as it is in the US, and we are starting to see the major oil companies’ earnings power build on the back of higher commodity prices. European financials have been through a long and painful de-leveraging process since the financial crisis and earnings are still half what they were a decade ago. However, better-capitalized firms such as BNP Paribas, Société Générale and Credit Suisse are now in a much stronger position to compete globally, in our view.
The technology sector is also worth a mention, even though European tech is one-tenth the importance of US tech to their respective markets. Tech earnings in the US are up 160% since 2007, but aside from giants such as software firm SAP, earnings in European tech companies have been underwhelming. We find it hard to believe the momentum in US tech will continue indefinitely but could see it picking up in Europe, helping to close the aggregate ROE gap between the two regions over time.
Beyond the turmoil: Finding European investment opportunities
Risks to European growth persist, but the market overreaction to data weakness and political uncertainty in the first half of the year has created opportunities. European sectors such as energy, industrials, financials and technology appear to offer some of the best tailwinds for investors, especially in relation to richer valuations seen in the US.
1FactSet, as of 7/3/2018
2FactSet Revere, as of 12/2017
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
Citi Economic Surprise Index
An index that tracks how economic data are performing relative to the consensus forecasts of economists. A positive reading indicates that economic releases have been beating consensus forecasts and a negative reading indicates that economic releases have been missing consensus forecasts.
MSCI Europe Index
An index that represents the performance of large and mid-cap equities across 15 developed countries in Europe.
MSCI Europe Small Cap Index
An index that represents the performance of small cap equities across 15 developed countries in Europe.
MSCI World Index
A broad global equity benchmark that represents large and mid-cap equity performance across 23 developed markets countries. It covers approximately 85% of the free float-adjusted market capitalization in each country and does not offer exposure to emerging markets.
Price-to-Book (P/B) Ratio
A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities.
Return on Equity (ROE)
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
S&P 500 Index
A market value weighted index of 500 US stocks that reflects the performance of a large cap universe made up of companies selected by economists.
A measure of risk-adjusted return.