Britain’s decision to leave the European Union (EU) reinforces the benefits of buying stocks when investors panic and valuations improve.
For all the handwringing about British exit (Brexit), the United Kingdom’s FTSE 100 index is up almost 10 per cent since the lows after the June 23 referendum and is back in bull territory. Key European market indices have rallied since Brexit and United States equities are in record territory.
Better-than-expected US jobs numbers last week, continuing signs of stabilisation in China and improving commodity prices have sparked the rally. Expectations of continued accommodative global monetary policy have outweighed Brexit fears.
Brexit, of course, is a huge challenge for the UK economy. But it seems unlikely to lead to the (EU) implosion as some commentators were quick to predict, or to weigh too heavily on global growth. Brexit might make the EU more supportive of troubled Italian banks – the market’s latest worry – and peripheral Eureopan countries that need help.
A lower pound will help British exports and its economy in time and its central bank may extend quantitative easing. Theresa May’s election this week as leader of the Conservative Party, and thus Britain’s Prime Minister, was well received by markets that are craving political certainty.
That does not mean the worst is over for markets. Far from it. I’m concerned that equities, bonds and gold are rallying in unison: bond prices and gold should be falling but perhaps investors are treating stocks with reliable yield as surrogate bonds.
Bond market pricing suggests a frightening outlook for the global economy. If bond investors are correct, the flattening of the US yield curve implies the world is heading towards a deflationary trap of lower prices and stagnant economic growth over many years.
Investors must look even harder for value in this low-growth environment, avoid overpriced assets and be prepared to buy during bouts of high uncertainty and media-fuelled pessimism.
British equities are a case in point. The National Australia Bank this week predicted that Britain is headed for a shallow recession following Brexit and that a UK slowdown will have little effect on global economic growth. The main risk is a spillover to European growth.
European equities appears to have priced a significant spillover and then some. A forward Price Earnings (PE) ratio on European shares of just under 14 times is well below that in the US and Australia (above 16 times).
In a note this month, BT Financial Groups’ head of market research, Tim Rocks, said: “Aside from the exaggerated break-up fears, we see European shares as an opportunity and would look to take advantage of any future weakness.”
I agree. European growth has been okay this year. Forecasters have revised Eureopan economic growth lower by about half a percentage point following Brexit – not great but not enough to tip the region into recession or justify sharply lower stocks valuations.
A falling euro will make Europe more competitive and will boost exports over time.
Moreover, doomsday predictions about a break-up of Europe after Brexit were overstated. Brexit ‘remorse’ was prominent soon after the vote and Britain’s decision might act as a deterrent to European countries considering following its lead.
The big issue is whether the EU will bail out troubled Italian banks – something the market appears to expect given this week’s rally in risk assets. Signs of greater EU support for the European financial services sector could give global equities another boost.
Investing is always relative and European equity valuations look a lot more attractive than those in the United States. The US desperately needs stronger corporate earnings growth, which may emerge in the upcoming quarterly earnings reason, to justify high stock valuations.
I first became bullish on European equities for The Bull in July 2013, noting the region as an interesting medium-term investment opportunity. That idea performed well until a sell-off this year.
Chart 1: iShares Europe ETF over five years.Source: The Bull
The simplest way to gain exposure to European equities is through an ASX-quoted Exchanged Traded Fund. The iShares Europe ETF is a good place to start. It provides exposure to the S&P Europe 350 index of large, mid or small-companies.
Key index members include Nestle, Novartis, Roche Holdings, HSBC, Royal Dutch Shell and GlaxoSmithKline. The ETF gives diversified exposure across European countries and sectors and includes some of the world’s best companies.
The ETF’s three-year annualised return (in Australian dollars) is 11.5 per cent. Over five years, it has delivered 9.4 per cent annually. So much for Europe being an investment basket case (although returns have been cushioned by the Australian dollar).
The iShares Europe ETF is slightly down year-to-date after strong gains this month. It could rally further as the market digests Brexit and greater clarity about Italian banks emerges.
A lower Australian dollar in the next 18 months, which I expect, would be another boost given the ETF is unhedged for currency movements.
Chart 2: iShares Europe ETF over one yearSource: The Bull
Tony Featherstone is a former managing editor of BRW and Shares magazines. The information in this article should not be considered personal advice. The article has been prepared without taking into account your objectives, financial situation or particular needs. Before acting on the information in this article you should consider the appropriateness of the information, with regard to your objectives, financial situation and needs. Do further research of your own or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at July 14, 2016.