By Jaisal Pastakia, Investment Manager at Heartwood Investment Management
European equities has been an unloved market over the past year, with performance lagging the US, UK and emerging markets. While it remains an out-of-consensus trade, recent developments have reinforced our view to maintain an overweight equity position to this region for the following reasons:
- A stabilising economic backdrop. Survey and sentiment data have seen encouraging improvements. The eurozone PMI manufacturing survey is at its highest level since 2011. New orders in particular came in at a five-year high, suggesting that, all else equal, confidence in the coming months remains robust. The gains are broad-based across countries with France seeing a meaningful improvement. In terms of actual activity, capacity utilisation – a measure of productivity – has been steadily improving over the past couple of years and is now back to the peak seen in 2008. This is an important indicator for future capital expenditure, which has been missing from the recovery cycle. In addition, domestic demand remains supported by low interest rates and tighter labour market conditions. While improvements to wage trends vary on a country by country basis, encouraging gains have been made in Germany and Spain. Indeed, consumer confidence remains at a multi-year high, despite headline political risk.
- Credit growth remains supportive. Low interest rates and abundant European Central Bank (ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-CENTENO-a52f21b9-8975-4dc5-9a21-8c5e8267aa43>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB) liquidity are keeping financial conditions loose. Demand for loans has improved in every country since the start of the ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-CENTENO-a52f21b9-8975-4dc5-9a21-8c5e8267aa43>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB’s quantitative easing programme in January 2015, with Germany and Spain accounting for the strongest increases. Concerns have eased around the impact of negative interest rates on banks’ profitability and their ability to lend, as longer-term interest rates have increased and bank share prices have recovered.
- Rising inflation expectations are generally good for European equities. History shows that this market tends to perform better when growth and inflation expectations rise globally. There are two reasons for this phenomenon. First, European companies derive 50% of their sales outside of Europe. Second, and more crucially, these companies tend to have a higher fixed cost base and are therefore are more sensitive to changes in sales, meaning that they should benefit more on the upside as sales pick-up. Flow data also suggests that US investors tend to invest in European equities as inflation expectations rise. European equities suffered from meaningful outflows in 2016 – almost as big as those seen in 2008 – but the pace has moderated since mid-October, coinciding with a pick-up in earnings upgrades.
- Corporate earnings growth is improving. Earnings-per-share growth turned positive in most regions in the third quarter of 2016, following four consecutive quarters of contraction. Financials and commodities are now expected to contribute positively to the aggregate earnings picture, with a weaker euro also helping exporters.
Inevitably, though, the political calendar in 2017 complicates this investment thesis, as event risk is likely to be at the forefront of global investors concerns. While political headline noise will contribute to short-term swings in investor sentiment, the main support for European equities is that we are now seeing real, fundamental economic improvements across the region, accompanied by prospects of stronger company pricing power and profitability.
Of course, there is further to go and the region’s governments are making slow progress to implement structural economic reforms. However, the improvements already seen should help to ameliorate some of the populist forces in key countries facing elections this year – the Netherlands, France, Germany and possibly Italy. Moreover, we take some comfort from the market’s response in the second half of 2016 to key political events, when investors looked through both the Spanish elections and the Italian referendum to focus on perceptions of stronger global growth prospects.
There is also a risk that investors become overly pessimistic about politics. The most likely outcomes in the Netherlands and Italy (if we are to seen an election here) are coalition governments due to their proportional representation systems, which would maintain the status quo. In Germany, there appears to be no credible opposition candidate to Chancellor Merkel and any headway on the migrant crisis should help to consolidate her support. In fact, the main opposition party, the SPD, has been making some gains in recent opinion polls but at the expense of extremist parties.
So this leaves France. Marine Le Pen is likely to be one of the final two candidates in the second round of elections. Under this scenario, we would look to the 2012 election as a precedent, when the centre left and centre right coalesced to support Francoise Hollande against Le Pen. We believe this could happen again to block the extremist movement. If so, there could be a realistic prospect that France could elect a ‘change’ candidate in favour of reforming the economy.
Investing in European equities is not necessarily for the faint-hearted, but we believe there is scope for this market to outperform this year.
By Jaisal Pastakia, Investment Manager at Heartwood Investment Management
European equities has been an unloved market over the past year, with performance lagging the US, UK and emerging markets. While it remains an out-of-consensus trade, recent developments have reinforced our view to maintain an overweight equity position to this region for the following reasons:
- A stabilising economic backdrop. Survey and sentiment data have seen encouraging improvements. The eurozone PMI manufacturing survey is at its highest level since 2011. New orders in particular came in at a five-year high, suggesting that, all else equal, confidence in the coming months remains robust. The gains are broad-based across countries with France seeing a meaningful improvement. In terms of actual activity, capacity utilisation – a measure of productivity – has been steadily improving over the past couple of years and is now back to the peak seen in 2008. This is an important indicator for future capital expenditure, which has been missing from the recovery cycle. In addition, domestic demand remains supported by low interest rates and tighter labour market conditions. While improvements to wage trends vary on a country by country basis, encouraging gains have been made in Germany and Spain. Indeed, consumer confidence remains at a multi-year high, despite headline political risk.
- Credit growth remains supportive. Low interest rates and abundant European Central Bank (ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-CENTENO-a52f21b9-8975-4dc5-9a21-8c5e8267aa43>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB) liquidity are keeping financial conditions loose. Demand for loans has improved in every country since the start of the ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-CENTENO-a52f21b9-8975-4dc5-9a21-8c5e8267aa43>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB-POLICY-SOURCES-e4bab80d-7aeb-4e49-a29a-ce14e1595c6d>ECB-POLICY-KAZIMIR-00b06d9b-4b99-46ce-a2aa-458d8eb2d993>ECB’s quantitative easing programme in January 2015, with Germany and Spain accounting for the strongest increases. Concerns have eased around the impact of negative interest rates on banks’ profitability and their ability to lend, as longer-term interest rates have increased and bank share prices have recovered.
- Rising inflation expectations are generally good for European equities. History shows that this market tends to perform better when growth and inflation expectations rise globally. There are two reasons for this phenomenon. First, European companies derive 50% of their sales outside of Europe. Second, and more crucially, these companies tend to have a higher fixed cost base and are therefore are more sensitive to changes in sales, meaning that they should benefit more on the upside as sales pick-up. Flow data also suggests that US investors tend to invest in European equities as inflation expectations rise. European equities suffered from meaningful outflows in 2016 – almost as big as those seen in 2008 – but the pace has moderated since mid-October, coinciding with a pick-up in earnings upgrades.
- Corporate earnings growth is improving. Earnings-per-share growth turned positive in most regions in the third quarter of 2016, following four consecutive quarters of contraction. Financials and commodities are now expected to contribute positively to the aggregate earnings picture, with a weaker euro also helping exporters.
Inevitably, though, the political calendar in 2017 complicates this investment thesis, as event risk is likely to be at the forefront of global investors concerns. While political headline noise will contribute to short-term swings in investor sentiment, the main support for European equities is that we are now seeing real, fundamental economic improvements across the region, accompanied by prospects of stronger company pricing power and profitability.
Of course, there is further to go and the region’s governments are making slow progress to implement structural economic reforms. However, the improvements already seen should help to ameliorate some of the populist forces in key countries facing elections this year – the Netherlands, France, Germany and possibly Italy. Moreover, we take some comfort from the market’s response in the second half of 2016 to key political events, when investors looked through both the Spanish elections and the Italian referendum to focus on perceptions of stronger global growth prospects.
There is also a risk that investors become overly pessimistic about politics. The most likely outcomes in the Netherlands and Italy (if we are to seen an election here) are coalition governments due to their proportional representation systems, which would maintain the status quo. In Germany, there appears to be no credible opposition candidate to Chancellor Merkel and any headway on the migrant crisis should help to consolidate her support. In fact, the main opposition party, the SPD, has been making some gains in recent opinion polls but at the expense of extremist parties.
So this leaves France. Marine Le Pen is likely to be one of the final two candidates in the second round of elections. Under this scenario, we would look to the 2012 election as a precedent, when the centre left and centre right coalesced to support Francoise Hollande against Le Pen. We believe this could happen again to block the extremist movement. If so, there could be a realistic prospect that France could elect a ‘change’ candidate in favour of reforming the economy.
Investing in European equities is not necessarily for the faint-hearted, but we believe there is scope for this market to outperform this year.
