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Europe awaits an earnings recovery

Investors should look past European political upheaval towards cyclical value in 2017
December 16, 2016

For pundits and their crystal balls, 2016 can be described as a year to forget. Brexit happened, Donald Trump won the US elections and European equities experienced nothing like the blistering showing anticipated by analysts.

The consensus last January had us believe that shares on the continent would outperform other regions, buoyed by cheap valuations and a monetary easing-inspired return to profitability. In truth, analysts have been forecasting the same for years, based on a growing conviction that the local and global economy will finally break out of the doldrums and awaken investors to the recovery potential of neglected European bourses.

A glance at the Stoxx Europe 600 suggests that this rotation has yet to occur. At the time of writing, the index, home to large-, mid- and small-cap companies spanning 17 countries, is down almost 11 per cent over the course of 2016.

Hefty exposure to troubled financial and commodity industries, a lack of share buybacks, weak pricing power and stuttering domestic and overseas growth were mainly to blame for this dispirited performance. That two of Europe’s closest partners are considering protectionist trade action didn’t sit too well, either.

 

Election year uncertainty rattles investors

Political uncertainty closer to home has added to these worries. After a triumphant year for populist policies and anti-globalisation rhetoric in other areas of the world, fears are developing that the bloc’s electorates may choose to follow a similar path.

Germany and France, which together account for about 40 per cent of regional GDP, are among a handful of European countries heading into an election year. Widespread discontent with the status quo and the emboldening effect that shock upsets in the UK and US have had on anti-establishment parties mean that markets can no longer discount the possibility of a new band of unpredictable politicians governing the continent.

“Too many promises have been made and not adhered to for too long,” says Tim Stevenson, fund manager of Henderson EuroTrust. “In Europe, the worry is that a high level of unemployment could create a fertile breeding ground for further protest votes. “Politics will... play a big role in 2017, with elections in the Netherlands, France and Germany for certain, others possibly. After 2016, making any prediction on those is even more risky, but I suspect that established parties will not be decimated in the way that we saw with Brexit and Trump”.

Driving this confidence is Mr Stevenson’s belief that policy makers will ease off on the austerity measures responsible for diminishing the wealth of populist party core voters. Together with a weaker euro boost for multinationals and another dose of fiscal easing, he reckons this will translate into better underlying demand and the long-awaited return of earnings growth for Europe Inc.

 

 

Recent data feeds optimism

While it’s only natural for a European-focused fund manager to talk up the region’s prospects, recent data helps to support his view. The flash eurozone purchase managers’ index (PMI), a closely watched indicator of economic activity, surged to its highest level of the year in November, climbing 4.1 percentage points above the level marking expansion. Consumer confidence also impressed in a period when many expected political uncertainty to erode appetite for spending.

Signs of economic health were reflected in impressive third-quarter corporate earnings from some of the continent’s biggest bellwethers. A return to top-line growth, driven in part by renewed confidence in emerging markets, triggered estimate-beating profits across cyclical pharmaceutical, auto and bank sectors. Aggressive cost-cutting also played a role in this turnaround, suggesting that previous efforts to rein in spending are now paying off.

 

Bulls find their voice, again

Unsurprisingly, analysts wasted little time heralding this moment as an inflection point, and signal that their previous predictions are starting to filter through. Following years of declines, numerous City brokers reasserted that European corporate profits will finally grow in 2017, and by quite a big margin –the consensus view is for earnings per share (EPS) to surge 12 per cent.

“The macro backdrop in Europe is... brightening”, say Morgan Stanley market strategists Andrew Pauker and Vijay Chandar. “While German bunds are pricing in no economic growth, eurozone data has improved recently. Manufacturing PMIs have ticked higher, as have key economic surveys and the Citi Euro Zone Economic Surprise Index, which has risen since mid-September.

“The upturn in the Morgan Stanley global trade leading indicator is a plus because trade has historically accounted for as much as 40 per cent of Europe’s GDP. Furthermore, European companies generally have more operating leverage than US companies, so every incremental improvement in GDP has a greater impact on earnings.”

 

Value investing back in fashion

Should these promising signs last long enough to have a material impact, cyclicals look set to be the biggest beneficiaries. Economic stagnation, quantitative easing (QE) and low bond yields have seen quality shares dominate portfolios since the global financial crisis, as investors sought shelter from volatility and income-seekers scoured equity markets for reliable dividends.

Of course, rampant demand for so-called bond proxies and companies capable of churning out steady returns in periods of low growth made them increasingly expensive to buy. Now that the environment driving this success appears poised to change, many have begun reassessing whether the wide valuation disparity between these assets and the rest of the market is still justified.

Speculation about the future direction of interest rates and inflation played a pivotal role in this rotation back to the long unloved strategy of value investing. Since the summer several policy makers have eased back from quantitative easing rhetoric, in favour of finding other more popular methods to revitalise sluggish economies.

Donald Trump’s victory added weight to these claims. The president-elect’s criticism of the Federal Reserve’s interest rate policy and pledge to invest billions of borrowed money went down a treat. It also saw 10-year bond yields soar, which together with a stabilising oil price, China’s exporting of inflation and wage hikes across various countries, has increased speculation that the price of goods is set to soar.

 

With uncertainty comes opportunity

One thing recent history has taught us is that investors should be hesitant about blindly following pundits’ predictions. For now, a sustainable eurozone economic recovery and shift in government policy remain speculation.

Amid all this uncertainty, investors would be wise to focus on areas of the market that are both undervalued and backed by solid fundamentals. Usually, finding such opportunities in closely watched equity markets is no easy task. In a year of political elections, Trump stories, Brexit debates and likely wild predictions, it’s equally reasonable to argue that these aren’t normal times.