While we are encouraged by the European equity market recovery since the UK’s EU referendum, the total return for the market is still down 4% in euro terms this year at the time of writing.
The strength of the FTSE100, up 12% in sterling terms year-to-date (YTD), has surprised many. This has been driven by exporters and the positive impact of weaker sterling post the referendum, but in euro terms the loss is similar at -3% YTD.
Corporate earnings have fallen short
Once again, the key driver has been disappointing earnings relative to expectations, particularly in financials and energy. Earnings have been downgraded from +10% in January and we expect will finish the year at -4%, therefore we have actually seen a modest re-rating of the market so far this year.
If we strip out energy and financials the picture is better with earnings growth this year at around +5% which may be significant as we look forward to the next 12 months. Interest rates can’t go much lower which should provide some support for the banking sector’s profitability and the year-on-year comparisons for the oil price will begin to ease as we go into 2017.
This of course pre-supposes that underlying earnings in non-financials and energy can hold up or improve going forward which, given the low inflationary environment we are in, is a big assumption. However, we continue to believe the European economic recovery is on track, albeit still sluggish, and the Brexit impact will be minimal.
Looking more internationally, the US appears robust and emerging markets are improving (although not universally) which should provide reasonable export markets for many European companies.
Italian referendum poses a risk
Italian Prime Minister Matteo Renzi is preparing to gamble his career and Europe’s political stability on a divisive referendum due to be held in early December. Renzi is attempting to cut the Senate’s powers to vote on laws and leave almost all legislation to the lower house — a change the prime minister claims will speed up the passing of laws Italy needs to reform its sclerotic economy and legal system.
However, Renzi may come to regret his initial promise to step down if he fails to win the referendum; indeed, he now seems to be back-tracking. This statement has prompted opposition parties to campaign not on the issue at hand, but to take advantage of the opportunity to get rid of Renzi. Indeed, recent polls suggest more than half of those likely to vote are voting on his future, and not on the merit of the constitutional reforms.
Other elections on the horizon also pose a risk. In the US, the equity market remains buoyant – a sign that Hillary Clinton, as the candidate of the incumbent party, is favourite to win the presidency. A decisive Clinton victory would probably be the best outcome for the equity market, not because of the Democrat win but because of the resultant political stability.
Donald Trump’s track record of supporting anti-establishment issues and candidates, such as Brexit and Russian President Putin, could legitimise eurosceptic groups. With the EU questioning its post-Brexit future, empowered fringe parties could potentially redefine the geopolitical landscape. Elections in France and Germany in 2017 should be more straightforward, but Brexit has taught us not to underestimate protest movements.
Bank profits under pressure, but capital positions have improved
Banks form c.15% of the MSCI Europe index and are therefore a significant contributor to performance for investors who prefer to invest in a market tracker. Active managers who took a dim view of banks will have likely outperformed in 2016.
However, the potential for large gains in this sector continues to polarise the market. On the one hand, many banks appear significantly undervalued relative to their long-term earnings potential. On the other hand, profits are likely to remain under pressure for the foreseeable future, given low interest rates in the eurozone look set to continue for an extended period of time.
The impact on the financial sector from a potential Deutsche Bank collapse would be very negative, but we think such a scenario is very unlikely. In the event of further distress, we would expect a bailout similar to what happened in the UK with Lloyds and Royal Bank of Scotland. In this case, equity holders of the stock would be the main sufferers.
Overall, European banks have improved their capital position in the last seven years; however, there are certain outliers such as Deutsche Bank and Banca Monte dei Paschi di Siena. If the sector continues to de-rate, this should provide active managers like ourselves with the opportunity to initiate positions in some of the more cash generative, profitable banks that are trading at a significant discount to the broader market.
Taking a longer-term perspective
So far we’ve talked about year-to-date market performance, short-term earnings prospects and near-term risks like the Italian referendum. Here at Schroders we take a long-term fundamental approach to investing in equities, so it’s worth considering the longer-term market outlook.
The US equity market is close to all-time highs with many commentators taking the view that valuations are extreme and caution is warranted. This is a prudent approach but Figure 3 below illustrates how the price-to-earnings (P/E) ratio1 of the US market has been increasing over the last 40 years as interest rates have declined. With interest rates at virtually zero it’s very difficult to attach a fair multiple to the market.
Lower interest rates are beneficial to equities for a number of reasons:
– As rates come down, investors seek more attractive opportunities away from money market and fixed income type products and equities are deemed more preferable.
– Equity valuations are the net present value (NPV) of future cashflows, so if discount rates go down, the NPV goes up.
– Typically lower interest rates are a catalyst for improved future economic growth (monetarism), which increases corporate earnings.
We’re not for a moment suggesting the market will move to 50x earnings, but it’s difficult to say the market is overvalued during this time of such low interest rates.
Valuation opportunity for European equities
The significant outperformance of the US market compared to Europe since the financial crisis we believe highlights an opportunity. Figure 4 below shows the US market is up 190% versus +70% for Europe since the trough in 2008.
The superior earnings profile of the US market compared to Europe explains the vast majority of the outperformance, as Figure 5 illustrates. The eurozone crisis, austerity and the general lack of confidence has meant European earnings have fallen behind substantially.
Scope for earnings recovery
We view this as an opportunity to invest in under-earning companies given the recovery potential. Furthermore, relative to history, the market is currently placing a low valuation on those depressed earnings. Figure 6 below shows the cyclically-adjusted price-to-earnings2 (CAPE) chart as a long-term valuation measure that has been a decent predictor of future stockmarket performance.
In addition, we should look at the underlying earnings trend. The earnings revisions shows one month revisions have entered positive territory for the first time since 2011, whilst the three-month figure shows an encouraging trend despite the data series itself being quite volatile.
If earnings and valuations at the market level provide some comfort, we should perhaps look at other factors and themes within the market that may help generate alpha (i.e. outperformance versus the benchmark).
Stockpicking critical as correlations wane
First and foremost is our belief that stock selection will be a key determinant of future portfolio performance over the coming years. Correlations have been elevated for some time as markets have been driven by macro themes and momentum. Figure 8 below shows correlations between stocks in the market are levelling off and we think are likely to break down, giving fundamental stockpickers a great opportunity to make money.
Some of the change in correlations could be driven by a reversal of the value versus growth theme3; indeed, many of the new and exciting opportunities we find in the market are at within the value space.
Growth and quality have had a multi-year period of outperformance and some of the valuation metrics are at extremes; for example, the food and beverage sector has never before had such elevated valuation multiples.
Conclusion – upside potential is significant
We expect the European economy to continue its gradual recovery over the coming quarters. The UK’s departure from the EU will continue to grab many headlines but will likely be a minor issue for the European economy unless sterling has a catastrophic meltdown which could systemically undermine confidence.
Growth stocks are those with high rates of growth, both current and projected forward, while value stocks are those that have been under-priced by the market and have the potential to rise in value.
Our central belief is that equities look attractive relative to other asset classes, particularly given lower interest rates for longer. Valuations and the potential earnings recovery in Europe could provide investors with significant upside assuming strong stock selection.
We believe the momentum trade is wearing thin and would advise clients to explore contrarian opportunities based on fundamental, bottom-up analysis.
Rory Bateman, head of UK & European Equities at Schroders