Still upside potential in Europe as growth hits 10-year high

Jonathan Boyd
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Still upside potential in Europe as growth hits 10-year high

After lagging most of the developed world since the global financial crisis, the EU economy witnessed a resurgence in 2017 – posting its fastest rate of growth for a decade.

The 2.5% growth rate for the bloc of 28 was the highest annual growth since 2007 – led by positive economic results from the Continent’s major economies. However, the UK posted the slowest rate of growth since 2012 last year, expanding 1.8%.

As the European economy continues its recovery path, what do investors make of the prospects for the region in 2018 and beyond?

Dean Tenerelli, portfolio manager of the T. Rowe Price Continental European Equity fund

Investors essentially looked through most short-term political worries in Europe in 2017 to focus on the stronger economic fundamentals the recovery in corporate earnings. The euro-area economy is growing faster than in the US and the recovery appears broad-based, but any tightening of monetary policy by the ECB should be limited as there are few signs of faster inflation.

On the corporate front, earnings expectations have been trending upward for the first time in six years. However, we expect earnings growth to be slower in 2018, mainly due to the stronger euro and as companies in some sectors struggle to offset input cost pressures from higher prices of raw materials.

Although many asset classes now appear to be fully valued, we believe further upside to European equities can be justified in this environment if progress on the corporate front can be sustained over the next couple of years. Despite a general increase in equity valuations, we are still finding some good opportunities. Our focus on growth-generating companies of high quality is well suited to Europe’s economic recovery.

Stuart Mitchell, manager of the SWMC European fund

The outlook for European equities remains very positive, as evidenced by the eurozone manufacturing PMI reaching a breath-taking 60.6 in December, the highest level since the survey began over 20 years ago. Perhaps more importantly, our company visits tell of a corporate sector recovery continuing to outpace more cautious market expectations.

As we have said many times before, the political backdrop in the eurozone is more stable than many in the Anglo-Saxon world perceive. President Macron, for example, has been able to pass his controversial labour market reforms. These revolutionary changes include the decentralisation of collective wage bargaining. This will particularly benefit businesses with fewer than 50 employees – which is 95% of all French businesses – by allowing management to negotiate directly with employees, rather than through a union body. Other changes include a cap on severance pay and easier redundancy rules for French employees of international companies.

Most strikingly, European markets remain good value – trading at an unusually large 36% Shiller P/E discount to the US. Many domestically orientated companies trade at even heftier 50%+ discounts.

Chris Hiorns, portfolio manager of the Amity European fund at EdenTree Investment Management

The fundamentals of the European economy remain strong, with additional room for growth. The European economy is at a much earlier stage in its cycle than the US and unemployment has yet to meaningfully fall in many parts of the eurozone, while wages have yet to rise.

Political risk in Europe is also being largely overblown. In fact, our major political concern is the spectre of instability in Germany, as its uneasy coalition settles into governing. The general rise of populism across the region has prompted the political class to pay more attention to wages and employment, which should be broadly supportive for the broad economy and consumer-led stocks.

With monetary conditions remaining accommodative, we expect construction to surge in Europe as growth begins to feed through. This will benefit builders and suppliers. Further, attractively-priced media businesses will particularly gain from a rise in discretionary spending. The main potential headwind to our positive outlook for stocks on the Continent is the continued strength of the euro.

Rogier Quirijns, senior vice president and portfolio manager at Cohen & Steers

Healthy economies throughout Europe are driving demand for commercial real estate, at a time when supply is generally limited – largely as a result of the Global Financial Crisis – and credit conditions remain supportive.

In addition, we believe valuations for real estate securities are attractive on an absolute basis and relative to global equities and especially compared to bonds. Real estate typically offers high and stable income compared to most fixed income categories and we believe this income will at least rise with inflation over time – protecting against rising interest rates.

We see attractive real estate opportunities across Europe and nowhere is this more evident than in Berlin – which has attracted both German nationals and immigrants with its low costs of living and doing business. It is estimated that 20,000 new housing units are needed each year to meet new and pent-up demand in the city. Yet the market has supplied only half this amount annually in recent years, which is helping to drive rents higher. Quality office space in Berlin is also scarce, with strong job growth driving low vacancy rates and rising rents.

Hartwig Kos, manager of the Oyster Diversified GBP fund at SYZ Asset Management

A lot of Europe’s headwinds have started to fade over the past year to 18 months, while monetary conditions have remained accommodative. This has clearly helped domestic consumption and investment – translating into very strong economic growth.

The ECB has barely started to roll down the ‘emergency’ monetary policy measures, implemented in the aftermath of the sovereign debt crisis protect the euro bloc from collapsing. Despite the strong pickup in activity, inflationary pressures in Europe have so far remained muted – but question marks about ECB policy are undoubtedly rising. Therein lies the risk for European equities going forward.

It is true European equities are cheap and corporate earnings are rising. However, it is also true further euro currency strength has the potential to undermine the case for European equities – particularly northern European exporters. The strength of the euro witnessed in 2017 had more to do with a fading away of political risks, as opposed to a change in the monetary policy. This means a repricing of expectations with regards to the ECB could lead to a materially higher euro. A level of 1.35 against the US dollar seems utopic at this point in time, but it is worth remembering the euro was even higher not a long time ago.