Using the past five years as a benchmark, 2013 ranks as a rip-roaring success for the eurozone. The region emerged from an 18-month recession in August and has been crisis-free since the Cyprus bail-out nine months ago. French president François Hollande tells us the crisis is over and most experts agree that a return to growth will happen in 2014. Even Greece thinks so. Yet, while local difficulties, both social and fiscal, hinder this undeniably fragile recovery, the most immediate threat is bubbling away thousands of miles to the west.
New Year hangover
When the US Federal Reserve begins winding down its $85bn-a-month bond purchase programme, as it inevitably will, Europe will likely catch a cold; the European Central Bank (ECB) says so in its latest financial stability report. "Risks are clearly tilted to the downside and continue to relate to a still high level of economic policy uncertainty both in the United States and Europe," it said. But financial institutions are much more resilient now, and the likelihood that a severe market shock will plunge the region back into recession is greatly reduced.
ECB president Mario Draghi deserves credit here. Declaring last year that "the ECB is ready to do whatever it takes to preserve the euro" was crucial, and a subsequent bond purchase program hauled borrowing costs in Spain and Italy back from the brink. Moves toward banking union are under way, too - the ECB alone will oversee the industry from next autumn - and interest rates have just been cut again. Yes, extra work is required to further limit future financial market stress - and even more sweat and toil to improve growth and solve the region’s jobs crisis - but there is at least a plan.
That the eurozone will return to growth next year is not in question. Following two years of contraction, both the International Monetary Fund (IMF) and Organisation for Economic Cooperation and Development (OECD) expect an increase of 1 per cent in GDP. True, compared with elsewhere that’s pretty anaemic - in the US its 2.6 per cent and the global economy is tipped to have grown by 3.6 per cent a year from now. But growth is growth, and certainly the economies of northern Europe will do far better.
Domestic strife
Most interested organisations have already issued major health warnings as a caution against complacency. "The recovery is real, but at a slow speed, and there may be turbulence on the horizon," OECD Secretary-General Angel Gurría warns. Indeed, eurozone unemployment, already running at a record 12.2 per cent (in Spain and Greece it’s 27 per cent), is unlikely to recede until 2015, according to the European Commission (EC), which blames the inevitable impact on domestic demand for its decision to rein in growth expectations.
"External demand is expected to pick up over the coming quarters, but less than earlier expected, on account of a weakened outlook for growth in emerging market economies and the appreciation of the euro," the EC warns. Some robust data and a coalition deal in Germany have kept the currency near a two-year high versus the dollar and a four-year best against the yen. And austerity is depressing spending, with both hard-up households and companies more inclined to pay down debt.
After a small uplift last month, the eurozone manufacturing purchasing managers' index (PMI) hit its highest since June 2011. Germany is growing fast and Italy looks poised to end its two-year recession this quarter. But France has slumped to the bottom of the PMI pile and Spain had a bad November, too. "There's still a lot to worry about in terms of the health of the eurozone economy," warns Chris Williamson, chief economist at Markit which carries out the survey. "Any substantial improvement to the region’s unemployment situation still seems frustratingly far off."
Credit where credit's due
Talk to analysts, however, and the mood is more optimistic. When taking a view on European equities in 2014, investors must "anchor it to the macro view", says Deutsche Bank. "Everything else follows." And analysts there are certainly excited about the new year. Avoid any deterioration in the regulatory environment for banks, and credit growth could easily switch from minus 1 per cent currently to plus 1 per cent, potentially ramping up GDP growth to 1.5 per cent and average PMIs to a much healthier 53-54.
Certainly, the stars are aligned. "The best moments to buy equities are when credit growth is negative and the credit impulse (a change in the flow of credit relative to economic activity) has the potential to turn positive and this is where we are in Europe," writes Deutsche (see chart). Given the ongoing stabilisation in credit conditions reported in the ECB's last bank lending survey, the odds are good. And this, the bank argues, is not yet priced in.
Which way for equities?
Both the MSCI Europe index and the STOXX Europe 600 have risen 13 per cent so far this year and currently loiter near five-year highs. Both trade on a forward PE ratio of 13, too, driven largely by multiple expansion rather than earnings growth. That’s within easy reach of a decade-high for the MSCI and well above the latter’s long-term average of 12. But, as we've written before, it is profit growth that will be the primary driver of share prices in 2014.
And, again, things are looking up. According to Goldman Sachs, European bourses are exiting a typically explosive, multiples-driven "hope" phase, and entering a more stable period of growth after what was undoubtedly a tough third quarter. True, returns will be more modest than in previous recoveries, but the broker still expects the improving macro outlook and better margins to drive profit growth of 14 per cent and expects this "steady, low volatility trending market environment could last for a long time".
That's no bad thing, but there is room for a positive surprise, or two. Multiples have typically increased following previous crashes as investors anticipate an eventual upturn in profits. With European earnings currently 30 per cent below trend, Deutsche Bank had anticipated a forward PE ratio of nearer 15 than 13, especially given substantial restructuring, operational gearing and increases in capital spending. And with low interest rates set to remain for longer, it now forecasts 12 per cent earnings growth in 2014 and a forward multiple of 13.5, up from 12.5 previously.
Most likely to motor
Our foray into Europe in 2013 was highly successful. Most of our tips - including EADS (Fr: EAD), Deutsche Post (De: DPW) and Royal Ahold (NL: AH) - rose significantly, generating an average gain of 13 per cent. Count long-running buy tips Volkswagen (De: VOW3), Daimler (De: DAI) and Akzo Nobel (Fr: AKZA), and it was substantially more. And with most operationally geared to the global recovery, we believe the future remains positive for these companies.
It certainly looks that way for the automotive sector. With demand for new cars rising fast in both China and the US, we backed VW, Mercedes-owner Daimler and French struggler Renault (Fr: RNO). All are up sharply, but have more to go given we've just had the first back-to-back increases in European car sales since September 2011, setting up a return to annual growth in 2014. There's a case to be made for luxury goods stocks, too, and construction plays given operational gearing to the upturn.
Banks also look grossly undervalued. Earnings forecasts are conservative and Europe-wide bank supervision should boost profits, argues Goldman Sachs. Diminishing risks should cut the cost of equity for banks, too, and narrow the deep discount to the rest of the market. And rising bond yields could do much the same for lowly-rated insurers. Next year may prove tougher for telecom stocks, though. Trading at a 9 per cent premium to their 10-year average, much of the modest growth potential already looks priced in.
