European equities - A fresh breath of life for investors?

Global investors have been steering clear of Europe for some time now. From 2014 - 2016, the European market underperformed the US by almost 30%. European equity funds recorded outflows of over USD 100 billion in 2016.

We highlighted in a report published in March that it was time to reinvest in European equities (“Buy before the squeeze”). The trend is taking shape today and is accelerating. European markets have since gained 6% in absolute terms and 10% vs US equities.

After a long period of appearing more compelling, US markets now probably have only limited further upside potential in the short term, at least in terms of relative performance vs Europe.

Political doubts have abated over the past few weeks in Europe, particularly in France where an openly pro-European government has been appointed.

We highlighted in the report that we believed once the French elections were over, global investors would pile back into the region. This is now the case, as Europe is the most attractive equity market.

Our rationale: Sentiment – Fundamentals – Squeeze

Sentiment

European services and industry sector PMI composite indices, on a regional scale and nationally in France and Germany, are bullish for European equities. Newsflow is extremely positive, including job creations, faster growth, and even resurgent inflation towards normal levels, which was unthinkable two years ago. 

The German economy is now close to full employment, boosting consumer confidence and also encouraging purchasing managers. The results of the French presidential elections were warmly welcomed by the markets and major economic decision-makers.

Fundamentals

Sources for corporate earnings growth currently differ, as a function of whether companies operate in Europe or in the US. The rise in EPS in the US has stemmed mainly from cost-cutting and share buyback programmes, whereas earnings momentum in Europe has resulted chiefly from dynamic sales growth.

Furthermore, cycle-adjusted PE ratios imply that Europe is now particularly cheap compared to the US.

In terms of valuation, the current spread between the US and Europe is at its widest level in several decades, in favour of Europe.

Europe has never been such good value compared to the US.

Lastly, de-equitisation is gathering pace, due to operations reducing total equity in circulation, such as share buybacks or mergers & acquisitions.

The appeal of European equities has encouraged the international corporate world to take a closer interest and launch major buybacks over the past year.

Squeeze

Until recently, global investors were underinvested in Europe but are now reinvesting in the region.

Their return is reflected in figures published over the past few weeks and the impact will be amplified by the thin trading volumes in Europe (squeeze effect).

Economic confidence indicators are extremely positive, with major political issues abating recently amid a fresh impetus in Europe. These factors, combined with the arrival of global capital into a narrower market, are providing Europe with the status of the most compelling region for equity investors.

In the short term, cyclical companies will be the first to benefit from the renewed momentum. In the longer term, innovative companies exposed to structural megatrends will outperform.