BNP AM

The official blog of BNP Paribas Asset Management

Are European stocks starting to fulfill their potential?

Towards the end of 2016, when investors were contemplating the political and economic outlook for the following year, most anticipated a smooth transition in the US to another Democratic president, accompanied by modest economic growth, while in Europe, Brexit signalled economic turmoil in the UK and further potential disruption from elections in Austria, the Netherlands, France and Germany. Equity allocations consequently strongly favoured the US over Europe.

Towards the end of 2016, when investors were contemplating the political and economic outlook for the following year, most anticipated a smooth transition in the US to another Democratic president, accompanied by modest economic growth, while in Europe, Brexit signalled economic turmoil in the UK and further potential disruption from elections in Austria, the Netherlands, France and Germany. Equity allocations consequently strongly favoured the US over Europe.

Just over six months later and the world has been turned on its head. The enthusiastic market reaction to Trump’s victory in the US presidential election led to substantial gains for US equities, but has been accompanied by significantly higher-than-expected political risk. Europe, by comparison, seems an oasis of calm and stability. While economists rein in their forecasts for US economic growth, estimates for Europe GDP growth are rising. Recent data has been better than expected in the eurozone, while it has disappointed in the US (see Exhibit 1).

Exhibit 1: Changes in the eurozone and US indices of economic surprises during the period between 01/07/16 and 01/06/17

european equities

Sources: Citibank, BNP Paribas Asset Management, as of 01/06/17

However, this broad consensus in favour of Europe should prompt investors to examine their investment thesis, because when a trade is so widely followed it is all the more at risk of reversing (remember all the long US dollar positions at the beginning of the year; the DXY index is now 0.5% below the level of 8 November 2016).

What are the pros and cons of an overweight allocation to European equities?

While evaluating the positive arguments for European equities, it is worth remembering that many of them were offered last year and the year before, even as European equities underperformed those in the US. The difference today is due to sentiment, which has turned in Europe’s direction, and corporate profits, which are rising more quickly in Europe.

One of the most compelling arguments for European equities is valuation, although this is more on a relative than an absolute basis. Based on earnings expected over the next 12 months, prices for both US and European equites are above average, just more so in the US than in Europe. Compared to the long-run average, the price/earnings ratio (P/E) for the S&P 500 is 26% higher while for Europe is it just 18%. The multiple of Europe relative to the US, however, is still below historical levels, suggesting that there is value in European large-cap equities. Market valuations relative to asset values are even more compelling for Europe, with European multiples far lower on an absolute basis (9% above the average in Europe compared to 38% in the US) as well as a relative basis (see Exhibit 2).

Exhibit 2: Valuations of European equity markets are attractive relative to valuations of US stocks (the graph shows Europe-US valuations for price/earnings and price/book for the period from 1975 through 31/05/17)

Earnings are next-twelve-month forecasts.

Sources: IBES, BNP Paribas Asset Management, as of 31/05/17

More important than valuations is the outlook for earnings, where again Europe offers better prospects than in the US. On the one hand this is not surprising given that earnings have been disappointing. The case for accelerating earnings growth in Europe now is based on margins in Europe being relatively low compared to those in the US. Although profits in Europe have finally begun to recover, expected levels of profitability are still well below the levels reached even in 2011 after the Global Financial Crisis, let alone the peak levels of 2007 (see Exhibit 3). In the US, by contrast, margins are forecast to exceed what was achieved then.

Exhibit 3: Forecast net margins for the US and Europe for the period from 2000 through 31/05/17european equities

Sources: IBES, BNP Paribas Asset Management, as of 31/05/17

It is these low margins that have ostensibly always argued in favour of European equities: profits should grow essentially because they have yet to do so. But it was in the US that the profit growth was actually realised. What has changed is that the potential for profit growth in Europe is finally turning into reality. Earnings for the first quarter of 2017 showed 36% gains for European profits compared to 15% in the US. Given how high expectations for margins already are in the US, it will be challenging for corporations to meaningfully boost earnings further. One hoped-for driver had been tax reform and deregulation, but the prospects for this are fading due to tumult in the White House as well dissention among Republicans about how exactly to achieve their aims. As a result, earnings expectations have risen much more sharply in Europe over the last six months (see Exhibit 4).

Exhibit 4: Over the last six months, earnings estimates (next 12 months) have risen much more sharply in Europe than in the US

Sources: IBES, BNP Paribas Asset Management, as of 31/05/17

The discussion so far has focused on large-cap equities, but the outlook for small-cap equities is also stronger in Europe than in the US. The performance of European small caps had initially sharply lagged that in the US as the hope for significant tax reductions for small and medium-sized enterprises in the US boosted equities there. As the prospects of tax reform fade, markets have retraced (see Exhibit 5).

Exhibit 5: Relative market performance of European small-cap equities  relative to US small-cap equities for the period from 01/07/16 through 31/05/17

Sources: MSCI, BNP Paribas Asset Management, as of 31/05/17

As with large-cap stocks, both valuations and earnings growth expectations continue to support a case for Europe over the US — small-cap valuations in the US are higher relative to those in Europe, and earnings estimates have risen by 11% in Europe since the US election compared to 7% in the US. As the recovery in Europe is behind that in the US, unemployment rates and consumer sentiment have not yet moved as far as they have in the US, implying that there is far more room for an upswing in consumer demand. Equally, business sentiment has not gained as much ground and credit growth is perhaps only now beginning to accelerate ,while in the US it is declining sharply from higher levels (see Exhibit 6).

Exhibit 6: Bank lending to corporates is declining in the US but showing signs of acceleration in the eurozone (the graph shows bank lending to corporates in the US and eurozone during the period from 2003 through 31/05/17)

Sources: ECB, US Federal Reserve, BNP Paribas Asset Management, as of 31/05/17

While the European recovery is gaining traction, there are still risks ahead. The ECB is expected is expected on 8 June to announce its plans for further tapering of its bond purchases. While ECB president Mario Draghi has signalled that the bank will move slowly, the ECB is still likely to end its programme by next year. How significant a risk is this to the eurozone’s recovery? Judging by the experience of the US and the UK when they ended their own quantitative easing programmes, not hugely significant. Economic growth was apparently unaffected by the end of central bank bond purchases in 2012 and 2013 (see Exhibit 7).

Exhibit 7: Changes in base money in the US, UK and eurozone during the period between 2007 and 31/05/17

European equities

Sources: US Federal Reserve, European Central Bank, Bank of England, BNP Paribas Asset Management, as of 31/05/17

The reaction of Italian equity markets to the announcement last week by Italy’s former prime minister Renzi that he was contemplating early elections illustrates that political risk is still a factor in Europe. The risk to European and global markets from Italy’s election is much greater than it was in France because not only is the probability of a victory by the euro-sceptic Five Star party greater than it was for the National Front in France, but sentiment towards the euro is far more negative in Italy. In the run-up to the French elections, European and French equities continued to gain despite French government bond spreads increasing by 60 basis points. Merely the announcement of the prospect of an election in Italy, by contrast, prompted a further widening in Italian spreads and a 2% drop in the Italian equity market.

Conclusion

Investors have been waiting for years for the conditions of relatively low valuations and margins to translate into higher returns for European over US equities. That seems finally to be happening as corporations begin to achieve meaningful profit growth. The pro-European election results so far this year have helped to boost investor confidence in the political outlook for Europe, and just when worries about Trump’s presidency appear to be growing.

Fundamentals have long favoured European equities and yet the performance of the asset class has until recently been nonetheless disappointing. What’s changed is that profits are rising and sentiment (for now) is again positive towards the region. Europe’s recovery has likely further to go than that in the US, and market valuations suggest that earnings growth can be purchased more cheaply in Europe than in the US. The key risk remains Italy. It may be a lovely place to go on holiday, but Italy is exactly the reason that investors cannot afford to relax when they do.


Written on 2 June 2017

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