EMU stocks underperforming US stocks so far in 2017 – blame it on the USD!

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With less than four months to go in 2017, returns of eurozone equities are failing to live up to the forecasts of most strategists and investors.

Instead of generating higher returns than the richly valued US equity market, eurozone equity markets have underperformed by slightly less than 2% so far this year (up to 7/09/2017 – see Exhibit 1; total returns in local currency based on the S&P 500 and MSCI EMU indices).

Exhibit 1: The MSCI EMU share index has underperformed the S&P 500 through 07/09/2017 (graph shows relative performance of MSCI EMU versus S&P 500 (lhs) and US dollar/euro exchange rate (rhs))

eurozone

Note: equity = returns of MSCI EMU divided by returns of the S&P 500 total return, in the respective local currencies. FX shows the change in the rate of euros for one US dollar in 2017 through 07/09/2017

Source: FactSet, BNP Paribas Asset Management, as of 07/09/2017

The underperformance of EMU equities relative to US equities in 2017 is surprising…

This result is all the more surprising given how much Europe has exceeded expectations on many fronts while the US has disappointed. Instead of rising populism in Europe and the risk of a eurozone breakup, politics have been largely benign and economic growth has accelerated. In contrast, President Trump and the Republican Party have delivered almost none of their pro-growth initiatives.

but the euro’s rally is a drag on the profits of eurozone corporates

As Exhibit 1 illustrates, however, the US dollar has also not met the consensus prognosis, falling by nearly 9% this year against a basket of currencies instead of strengthening on the back of fiscal stimulus and interest rate increases by the US Federal Reserve. The even bigger gain of 14% in the euro will drag on eurozone exports and on corporate profits, either through reduced sales if companies reflect the currency’s rise in higher prices for exported goods, or in lower profits as foreign sales are translated back into euros at a poorer exchange rate.

Estimates of future eurozone corporate profits are beginning to integrate the negative impact of a stronger euro…

Equity analysts are belatedly beginning to reflect the impact of the euro’s moves in their estimates of corporate profits (see Exhibit 2). For most of the year, earnings revisions have been stronger for eurozone companies than their US counterparts. There was a dip in the summer due to the drop in oil prices, which affected Europe more as, unlike the US, the region does not have a significant oil fracking industry to offset losses for oil majors.

Exhibit 2: Next-twelve-months earnings estimates for corporates in the eurozone and US (indexed at 100 from 31/03/17 through 07/09/17)

eurozoneSource:  FactSet, BNP Paribas Asset Management, as of 07/09/2017

Eurozone corporates do extensive business outside the eurozone, so the exchange rate matters….

More recently however, revisions have been weaker in the eurozone, particularly for those sectors which have a higher share of their revenues coming from sales outside of the currency area, such as healthcare and consumer staples. In the same way that some countries are more export-oriented and thus more sensitive to currency movements, so are some sectors. For the MSCI EMU index as a whole, approximately 53% of sales are made outside the eurozone, but several sectors have a much more significant exposure (see Exhibit 3).

Exhibit 3: Share of non-eurozone revenues by sector

eurozoneNote: HLT = healthcare, I-T = information technology, MAT = materials, C-D = consumer discretionary, C-S = consumer staples, IND = industrials, EMU = MSCI EMU Index, EGY = energy, FIN = financials, TEL = telecommunication services, UTY = utilities, RST = real estate.

Source: FactSet, BNP Paribas Asset Management, as of 07/09/2017

The extent to which a country’s equity market is sensitive to currency movements is not the same as the sensitivity of its economy to currency movements…

In assessing how much sensitivity a country’s equity market has to currency, it is important to distinguish between the economy and the stock market. An economy’s exposure is best measured by the trade-weighted index, which takes the currencies of all the country’s trading partners and weighs them by the amount of trade done with them.

For the eurozone as a whole, based on the JP Morgan index, China carries the biggest weight at 18.3%, followed by the US at 12.5% and the UK at 9.5%. Emerging markets represent 57% of the trade-weighted index, which highlights why growth in China and other developing countries is always considered so crucial for the outlook of the eurozone.

For eurozone equities, it’s the US dollar versus the euro that matters

The equity market is somewhat different, however. The highest share of eurozone company sales outside the currency area are in fact to the US at 33%, followed by the UK at 11.3%. China’s share is just 10.1%, and for emerging markets as a whole it is just 39% (see Exhibit 4). Given that the strengthen of the euro has been most pronounced versus the US dollar, the recent weakness in earnings revisions is unsurprising.

Exhibit 4: Share of non-eurozone corporate revenues by currency and year-to-date change in foreign exchange rates

eurozoneNote: R$ = Brazilian real

Source: FactSet, BNP Paribas Asset Management, as of 07/09/2017

Equally, some countries are more dependent than others on exports outside of the region. The reputation of Germany as a country that has benefited from a weak euro is warranted, in our view,  as its equity market has an above-average share of revenues coming from outside of the region (see Exhibit 5).

Exhibit 5: Some EMU member states depnd more than others on exports outside of the eurozone – share of non-eurozone revenues by country

eurozoneSource: FactSet, BNP Paribas Asset Management, as of 07/09/2017

The currency, of course, is just one of many factors that drive the performance of the stock market, but it does seem to have some explanatory power. The average return for the four countries with below-average non-euro revenue exposure is 16% so far this year, while the average return for the countries with above-average exposure is half that, at 8%.

How much difference has the appreciation of the euro made to  earnings estimates?

Despite the drag on revenues from the stronger currency, estimates for 2017 have nonetheless risen by 2.9% since the beginning of the year. If there had been no change in the exchange rate, however, that gain would likely have been 7.5%. Given that the trade-weighted euro has gained 6%, this shortfall seems in line.

The question at this point, however, is the outlook

If analysts have largely adjusted their estimates for the currency moves, and if valuations, economic growth and corporate margins still argue for an outperformance of eurozone equities (as we believe they do), then earnings estimates should resume their upward trajectory. There is still time for eurozone equities to cross the 2017 finishing line ahead of those in the US.


Written on 07/09/2017

Daniel Morris

Senior investment strategist, CFA charterholder

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