OPINION 

Europe's cheapest markets

Dominic Picarda

Europe's cheapest markets

It is coming up for two years since European Central Bank (ECB) president Mario Draghi made his famous commitment to "do whatever it takes" to save the euro. The results of his words have been dramatic. The single European currency - whose very survival seemed to be hanging in the balance - has strengthened from around $1.20 to as high as $1.40. The DJ Euro Stoxx 50 index of leading European equities has shot up by 40 per cent. Ten-year bonds issued by the governments of Italy, Spain and Greece delivered stunning returns of 42, 53 and 420 per cent, respectively.

The eurozone economy has also picked up since Mr Draghi's reassurance. Having been mired in recession until early 2013, it has now grown for four quarters in a row. Even some of its worst-affected member states such as Spain have seemingly turned a corner. The Spanish economy has now expanded for three quarters on the trot, and at a quickening pace. Having been widely billed as likely to default on its debts back in 2012, that nation is now able to borrow money more cheaply than the mighty US.

1. Euro comeback (US$)

Source: Thomson Datastream

 

While it has been a long time coming, the ECB is at last matching its words with deeds, albeit mild ones. In early June, it said it would penalise banks who hoarded cash, rather than lending it out, and also revealed other measures to spark the financial system into lending to businesses. This therefore makes an obvious time for us to weigh up the outlook for European stocks and other assets.

 

Is it too late to buy Europe?

With the price of so many European equity indices already having risen so much, it is tempting to think that the best of the opportunity might have already passed us by. A good rule-of-thumb in the markets is to "buy the rumour and sell the fact", in other words, investing upon the first hint of positive developments to come and then taking profits once they actually happen. In this instance, the rumour may have been Draghi's strikingly worded yet vague commitment in July of 2012, while the fact might have been the ECB's decision to charge banks for hoarding funds.

What's more, European equities are now widely seen as a 'crowded trade'. In May, a net 36 per cent of asset allocators polled by Bank of America Merrill Lynch said they were betting more heavily on eurozone stocks at the expense of other regions. Such widespread optimism has a nasty habit of giving way to disappointment for investors. "Within Europe, investors are all aboard the periphery train, and there's now simply no margin for error," explains Obe Ejikeme, a European equity and quantitative strategist at Merrill.

The huge gains in stock and bond prices since 2012 may have run well ahead of the improvements made in European economic and corporate health. While an ever-deepening slump and currency collapse have been avoided - at least for now - Europe as a whole is hardly booming. In the first quarter of 2014, France experienced virtually no growth at all, while Italy and Portugal actually shrank at rates of 0.1 and 0.6 per cent compared with the previous three months.

 

Lingering risks

Many of the eurozone's underlying weaknesses remain. State borrowings were equal to 93 per cent of the size of the eurozone's economy in 2013, up from just 66 per cent when the crisis struck in 2007. The problem is especially acute in countries like Portugal (129 per cent), Italy (133 per cent) and Greece (175 per cent). At the same time, these nations are not achieving the sort of economic growth needed to keep their borrowings from swelling yet further in the future.

The strength of the euro - stemming from investors' relief at the currency's survival - could also choke off the economic recovery. An overly dear exchange rate tends to hurt overseas demand for European goods and services. At the same time, cheaper imports could tip certain countries closer towards price deflation. Stubbornly falling prices can discourage businesses and consumers from spending today in the hope of yet cheaper prices tomorrow, which in turn can hurt profits and swell the burden of existing debts.

Despite these stark risks, there are still no shortage of opportunities in Europe. For example, there is plenty of room for reform. The Mediterranean economies, in particular, are riddled with outdated working practices, cossetted trades and industries, and stifling restrictions upon business. Tackling these problems would inevitably meet with angry resistance from vested interest groups, but short-term gains for investors and long-term gains to the economy would make it wholly worthwhile.

Whereas central banks in the US and UK are edging towards higher interest rates, the ECB's growing willingness to ease monetary policy could produce economic and financial benefits. First, cheaper borrowing costs and greater availability of credit could enable many credit-starved businesses - especially smaller ones - to start investing more heavily once more. And, if the ECB eventually prints money in order to buy bonds, the prices of stocks and other risky assets could shoot higher still, as they have in the US, in particular.

 

Cut-price Europe

Despite the big run-up in European stock prices since mid-2012, many European stock markets still offer good value. Their valuations are still cheap when compared to other developed markets and also to their own historical valuations. Traditionally, such ratings have pointed to good returns to come.

Looking cheap on Cape

MarketCAPEDividend yieldPrice/book
Greece5.40.41.2
Austria11.72.82.2
Italy12.42.51.2
Netherlands13.02.21.8
Finland13.33.72.1
Spain13.84.01.7
Ireland14.11.01.8
Portugal15.02.71.6
Belgium15.61.91.8
France15.92.91.6
Germany16.52.51.8

Source: Thomson Datastream

 

Eurozone indices score especially well based on cyclically-adjusted price/earnings or 'Cape'. This metric - popularised by professor Robert Shiller - compares the price of a stock market today to its inflation-adjusted earnings over a decade. Spain, Italy, Ireland, Austria, the Netherlands and Finland all sport Capes in the low teens. By way of comparison, the UK is rated on a Cape of almost 18, Japan on 22 and the US on almost 24.

 

2. The cheaper continent: Cape ex-UK

Source: Thomson Datastream

A similar picture emerges from price/book values, which compares prices to the value of the assets behind them. Spain, France, Italy, and the Netherlands all trade on multiples below their historic averages. If the economic recovery takes hold and feeds into fatter profits, these valuations leave plenty of room for further gains.

 

What to buy

Overall, eurozone equities still offer an opportunity. But what is the best way of trying to ride further gains in these stock markets?

One possibility is to seek solid, broad-based exposure by investing in a product that tracks the Euro Stoxx 50. This index covers leading blue-chip shares from the eurozone. Given its make-up of gigantic companies, including Banco Santander, Nokia, Philips and Total, and also its decent representation from the economic powerhouse Germany, this might be seen as a lower-risk - and therefore lower-return - way of getting involved.

A more adventurous approach would be to buy individual countries' stock markets, especially the cheaper, riskier ones. For example, buying trackers on the four indices with the lowest Cape ratios in the eurozone would be one way of achieving this.

Another option is to invest in specific themes and sectors that could benefit more from the ECB's latest initiatives. According to Goldman Sachs' Portfolio Strategy Research team, the ECB's actions should make credit cheaper and more available to European firms. This, they say, should boost companies that carry a lot of debt, as well as those whose shares have high dividend yields. It highlights banks as well set to benefit from cheaper funding costs, which will let them shore up their balance sheets further.

Smaller companies could also enjoy a disproportionately big uplift amid easier monetary conditions, according to Goldman. In the past, such stocks have tended to outperform their larger peers when credit spreads - the gap between what it costs companies and governments to borrow - have narrowed. Smaller companies are often clustered in more economically sensitive areas of the economy and attract most attention from investors when times are good.

 

How to invest in Europe right now

The easiest way for UK investors to get Eurozone exposure is through an exchange traded product (ETP) listed on the London Stock Exchange. ETPsn offer quick, efficient and typically cheap access to foreign indices, as well as to particular themes. There are currently dozens of such products on offer, which allow investors to track the Euro Stoxx 50, the equivalent mid-cap and small-cap indices, individual industries such as insurance or healthcare, as well as strategies such as high dividend yield shares.

While eurozone stocks offer plenty of potential for upside, UK investors need to take account of currency issues. If the currency bloc is to enjoy a sustained recovery, the euro almost certainly needs to weaken. Should the euro come down significantly against the pound, UK holders of European shares would give up at least some of the gains from a rising equity market.

 

3. Currencies & stocks

The ideal solution would be to buy funds with an in-built sterling hedge, such that a 10 per cent gain in the European index involved would switch directly into a 10 per cent profit in sterling terms. However, such funds are few and far between, with most being funded in euros. Another alternative is to buy into a London-listed dollar-funded European ETF, of which there are quite a few. This would be especially worthwhile were the US dollar to strengthen against both the euro and against the US dollar.

 

How to profit from the eurozone opportunity

When I first came across continental European stock markets 30 years ago, most British investors saw them more as exotic, emerging opportunities, wholly unlike the well-established UK market. North America and Australia were about as far afield as most investors in this country were willing to stray.

Much has changed since then. Since the creation of the euro, the single currency area has become a highly investible region for investors from all around the world. US speculators have certainly shown great interest in Europe over recent months and at Pan Asset, we still see it as an interesting opportunity, especially given the ECB's latest steps to boost lending and growth.

Overall, we do not see European equity valuations as overwhelmingly cheap. However, we do think they are appealing, particularly since corporate earnings are forecast to jump this year. At 3 per cent, the region's dividend yield is also attractive and the dividends have room to grow if earnings do, indeed, stage a comeback.

Europe vs the world

IndexP/E 12m fwdConsensus EPS growth 2014Return on EquityP/BVDividend yield
S&P 50015.51014.52.71.9
Nikkei 225151081.71.4
MSCI Europe ex UK13.4168.31.53.1
FTSE 10013911.81.93.6
MSCI Em Mkt Latin America12.518.511.61.73
MSCI EM10.611.412.71.52.5
MSCI China8.99.215.51.43.4

Also, since eurozone corporates overall are cheaply rated in relation to their underlying assets, they may make especially logical takeover targets, which in turn would mean windfall gains for investors.

Although we have come to speak of 'eurozone' shares, this takes in a broad spread of very different national markets. Investors can either go for exposure to a Europe-wide index such as the EuroStoxx 50 or focus on particular countries, both of which can be done via ETPs. Other options include tracking indices of continental smaller companies, growth or value shares. A sample of the offering is shown in the accompanying table.

Sample of European stock offerings

NameTotal expense ratio/ongoing chargesReplication method
db x-trackers Euro Stoxx 50 ETF

0.09

Physical – Replicated

db x-trackers DAX ETF

0.09

Physical – Replicated

iShares Euro Total Market Value ETF

0.4

Physical – Replicated

iShares Euro Total Market Growth Large ETF

0.4

Physical – Replicated

db x-trackers Euro Stoxx 50 ex-financials ETF

0.2

Physical - Replicated

BlackRock Continental European Index Fund

0.18

Physical - Replicated

UBS MSCI EMU GBP Hedged ETF

0.33

Physical - Replicated

iShares MSCI EMU Small Cap ETF

0.58

Physical - Optimised

SPDR S&P Euro Dividend Aristocrats ETF

0.3

Physical - Replicated

iShares MSCI Europe Minimum Volatility

0.25

Physical - Optimised

SPDR Euro STOXX Low Volatility ETF

0.3

Physical - Optimised

Source Russell Europe SMID 300 ETF

0.35

Synthetic

Vanguard Developed Europe ETF

0.15

Physical - Replicated

iShares Euro Govt Bonds 1-3 ETF

0.2

Physical – Sampled

iShares Barclays 0-3 Year Euro Corporate Bond ETF

0.2

Physical - Sampled

iShares European Property Yield ETF

0.4

Physical - Replicated

The most liquid way to invest in the region is to buy into the DAX 30 index, which is made up of the largest firms from the eurozone's powerhouse economy, Germany. Both iShares and db x-trackers have UK-listed DAX30 ETFs. German exporters - who are well represented in the DAX 30 - should reap gains if the ECB succeeds in pushing down the euro, which could boost their revenues and profits.

With that in mind, it is essential for UK investors to think about the currency implications of buying eurozone stocks. Gains from rising stock markets can be at least partly offset by exchange rate losses, as unhedged investors in Japanese stocks have learnt in the last 18 months. There are few sterling-hedged trackers currently available, but there is a very useful equity ETF from UBS which tracks the EMU index of larger European countries.

Aside from eurozone equities, investors can also pick from a wide range of fixed-income trackers that give exposure to both government and corporate bonds. Although eurozone bond yields are at very low levels, yields could fall further and prices rise if the ECB decides to drive interest rates lower still or begins to print money to buy up bonds. In turn, this would likely stimulate European property shares, which are typically sensitive to bond yields.

Christopher Aldous is managing director of Charles Stanley Pan Asset

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