Europe has tantalized as an investment opportunity over the past few years. It has offered better equity market value than the U.S., a low-inflation spare-capacity economy supported by ultra-accommodative monetary policy, and a corporate profit recovery underpinned by relatively low margins. This theme began to pay off in 2017 as the Eurozone clawed back some of its equity market underperformance.
However, Euro-area stocks have given up these gains over the last few months. Europe has been hit by turmoil around the new Italian government, Spanish bank exposure to Turkey, trade-war fears and uncertain Brexit negotiations. The economy has underperformed over the first half of the year, and corporate profit expectations have been revised lower. This is a notable contrast to the U.S., where profits and economic indicators have surpassed expectations.
The fundamental case for Europe has weakened and we’ve downgraded our cycle score from +1.5 at the beginning of the year to +0.5 in June (on a scale from +2 to -2). Even so, we see a case for holding onto Euro-area exposure. This is based on the business cycle continuing to be a tailwind for equities, sentiment moving oversold, economic surprise turning positive, and the risks from Italy, Turkey and Brexit looking less threatening than a few months ago.
Italian political turmoil has calmed and there are indications that an Italian budget agreement is close. The nationalist coalition of Lega and 5Star Movement political parties apparently seek to avoid triggering a bond market crisis. We view Turkey as a bigger risk at quarter-end and further devaluation in the lira could return the spotlight to the exposure of Spanish banks. These however, appear manageable, and seem unlikely to create broader contagion within the Euro-area banking system.
Negotiations on the UK’s withdrawal from the European Union (EU) are moving towards their final and most uncertain phase. A sanguine “soft Brexit” outcome seems likely but there is potential for volatility along the way.
The most significant risk to Europe comes from an escalation in trade wars. Exports to emerging markets account for 9.7% of GDP for the Euro-area compared to only 3.6% of GDP for the U.S. The bigger risk in our view is that President Trump enacts additional tariffs against Europe on top of the 25% steel and 10% aluminum tariffs already imposed. One positive is that Trump sounded conciliatory in his recent meeting with European Commission chief Jean-Claude Junker. Another is that the U.S. Congress is not generally supportive of further trade sanctions against Europe, in contrast to the broad Congressional support Trump is receiving for his stance against China.
Business cycle: The Euro-area economy slowed over the first half of 2018. There were a few one-offs that contributed to the slowdown, including severe winter weather, labor strikes in France and the political turmoil in Italy. Even so, GDP growth at 2.1% in the year to June is still above potential of around 1.5%. Credit growth is picking up, and the weaker euro along with low interest rates mean that financial conditions are still supportive of continued above-trend growth.
Valuation: Eurozone equity valuations are neutral while core government bonds are long-term expensive. The chart shows price-to-book-value and a cyclically adjusted P/E ratio using the average of inflation-adjusted earnings over the past seven years. Both are near their long-term average. European equities don’t look particularly cheap or expensive.
MSCI Europe ex-UK Index
Source: Thomson Reuters Datastream, MSCI as of August 31, 2018.
The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, is a valuation measure usually applied to the S&P 500 equity market. It is typically defined as price divided by the average of 10 years of earnings (moving average), adjusted for inflation.
Indexes are unmanaged and cannot be invested in directly. performance quoted represents past performance and should not be viewed as a guarantee of future results.
Sentiment: Equity price momentum is flat. There are some oversold technical indicators, but these don’t appear strong enough to make us confident in a rebound. The most promising contrarian indicator is the Citi Economic Surprise Index. This tracks economic data releases relative to industry consensus forecasts. Europe moved from strong positive surprise in late 2017 to deep negative surprise in June 2018. Surprise since then has steadily moved towards becoming positive with forecasters becoming more pessimistic while Europe continues with above-trend growth.
Citi Economic Surprise Indices
Source: Thomson Reuters Datastream, last observation September 11, 2018. Indexes are unmanaged and cannot be invested in directly. Performance quoted represents past performance and should not be viewed as a guarantee of future results.
Conclusion: Euro-area equities look fairly-valued, have modest cycle support and appear slightly oversold from a contrarian perspective. The positive arguments are that economic surprises are moving from deeply negative to positive, meaning Europe should start to beat scaled-back expectations. Italian risk is fading and European bank exposure to Turkey looks less alarming than originally thought. The main risk in our view as we look toward the fourth quarter is an escalation of U.S.-China trade war. Europe has a large trade exposure to emerging markets and could be in the firing line for more automobile tariffs. Overall, the risks that dominated the past quarter seem to be getting smaller, the economy is likely to beat low expectations, and we believe earnings forecasts have potential for upside revision.