Can Europe reverse $43b drain in stocks?

Here’s what can go right and wrong for the continent’s equities before Christmas

Another quarter is coming to an end, bringing the same old disappointment for European equity bulls.

The Stoxx Europe 600 Index is up just 1 per cent since June 30, compared to a 7 per cent rally for the S&P 500 Index. With political concerns a constant thorn, investors continue to pull money from European equity funds, and there looks to be no end in sight to this year’s net $43 billion outflow.

Yet not everyone is deterred. Money managers at Allianz Global Investors, Barclays Investment Solutions and DWS are betting the fourth quarter will finally bring a European rally given stocks’ discounted valuations relative to the US, strong dividend prospects, and the promise of economic recovery and political stabilisation.

Let’s look at what can go right and wrong for European equities before Christmas:

■ How low can it go? It’s starting to sound like a broken record, but European stocks are still really cheap compared with the US. On a forward price-to-book ratio basis, the difference between the S&P 500 and the Stoxx Europe 600 is near the highest since at least 2005.

“Valuations in Europe have moved to attractive levels,” said Edward Park, investment director, Brooks Macdonald Asset Management in London.

■ Can’t get cheap enough: But European equities are still more expensive than emerging markets, making Credit Suisse Group AG and Brooks Macdonald fund managers prefer EM, despite risks. The MSCI EM Index, which trades at a near 20 per cent discount to the Stoxx Europe 600 index, has outpaced European stocks in 2016 and 2017 with a total return of 46 per cent, compared to an 18 per cent gain in dollar terms for the Stoxx 600 over the same period.

■ It’s all about earnings: At the end of the day, the discrepancy in performance of European versus US stocks comes down to earnings growth, with this year’s US tax reform having fuelled a profit boom among American corporations. Companies in Stoxx Europe 600 Index are expected to see 5.7 per cent profit growth in 2018 and a 9.1 per cent increase next year, it’s estimated. This is a stark contrast to US forecasts of 24 per cent for this year and 11 per cent next year.

■ Bank on banks

The banking sector is one of Europe’s worst performers this year due to disappointment over European Central Bank’s decision not to hurry rate increases, but the tide started to turn in September. Citigroup strategists called European bank shares “the world’s biggest contrarian trade” and Credit Suisse noted the region’s lenders offer the highest dividend payout relative to the broad market since the 2008 financial crisis.