The European equity blues
The relative performance of European stocks has been disappointing lately. Even though the European Central Bank delivered its promised easing, triggering both a further decline in peripheral bond yields and a weakening of the euro, eurozone stock markets have underperformed the US by 6% since early June in local currency terms, and by 7.25% in US dollars. However, there are two ways of looking at any sell-off. Either it is the beginning of a new downward trend, or it presents a good buying opportunity. Although investor confidence has clearly taken a beating in recent weeks, in this instance the balance between financial and economic conditions does not point to a prolonged weakness in European equities. thus, the coming weeks should offer investors attractive buying opportunities ahead of a stronger fourth quarter.
A nasty combination of heavy US fines on European banks, western sanctions on Russia, and an isolated but painful financial bankruptcy in Portugal accounts for much of Europe’s recent poor performance. Even so, European stock markets have proved disappointingly fragile. In early July, we argued that a strong US economy, a proactive ECB and a declining euro would be enough to keep eurozone stock investors engaged even as the acceleration in growth paused. But, mea culpa, we were too optimistic. Instead, the lack of momentum in corporate profits has made investors very nervous. Indeed, the difference in price performance between US and European stocks mirrors the divergence of growth in forward earnings per share since the end of last year: up 5% for the MSCI US, versus –0.5% for the MSCI EMU (in local currency terms). Taking a longer view, even the recent correction is still consistent with the idea that European markets are stabilising after five years of dramatic underperformance from 2007 to 2012. What is new is that the correction has taken place against a backdrop of declining monetary and systemic risks in Europe. Since January, longterm Spanish bonds have outperformed even US stocks, and the crucial OAT-bund spread has declined to just 35bps, from 60bps at the end of last year. Holding a basket of European bonds has thus proved to be a good hedge for equity portfolios.
Skeptics will argue that the decline in European bond yields is just more evidence of looming deflation, and that rejoicing today about lower interest rates in Europe is as short-sighted as it would have been in Japan in the 1990s. We disagree. Even though German bond yields have registered new lows recently, by far the best performance was returned by bonds that carry a ‘credit risk’, not by safe haven plays. This encouraging development is paralleled by improving prospects for domestic growth in key areas. Spain, which until recently was the largest deflationary maelstrom in the eurozone, grew by an annualised 2% in real terms in the first half of the year. In the service sector—which is more domestically-driven than manufacturing—the eurozone purchasing managers index set a new high for this cycle in July, while retail sales rose 2.4% year-on-year in June, the highest reading since 2007.
Granted, there are major areas of concern, notably in France and in Italy, where GDP declined -0.2% in the second quarter, contradicting the positive message sent by business and consumer surveys. Even so, investors’ fears over corporate profits are exaggerated. The aggregate level of corporate earnings has temporarily been dragged down by a severe profit recession in the telecom and energy sectors, and exchange rate moves whose impact is now in the past. We are especially comforted by the favourable momentum in the European ‘Mittelstand’-forward EPS are up 16% YoY in the small cap universe. The game of chicken with Russia may put pressure on eurozone exporters-Adidas, for example, has downgraded its growth forecasts- but exports should accelerate again by the end of the year as US growth picks up. And with the euro now lower, exporters’ profits should benefit more than in the recent past. All in all, the current balance between cyclical and financial conditions does not signal a prolonged weakness in European equities. Yes, frustration about the eurozone’s economic performance, investor impatience over earnings growth, and concerns about tensions with Russia might leave eurozone markets looking vulnerable in the near-term, especially with Wall Street’s volatility rising. But we still recommend buying the dips in expectation of a better fourth quarter, when the uncertainties surrounding the ECB’s Asset Quality Review will have been settled. Meanwhile, continue selling the euro as a hedge.