• After favouring Europe for several years, investors now appear to be abandoning the region. European equity markets have suffered seven consecutive months of outflows since end of January 2016 and the year-to-date performance of most European equity indices has been negative, despite a 13th consecutive quarter of positive eurozone GDP growth in the second quarter.
• A major reason for this negative sentiment towards Europe is rising political instability-not least the recent UK referendum vote to leave the European Union (EU). Worries over persistently low inflation, and disappointment over the lack of a sustained recovery in corporate earnings have also hit investor confidence.
• However, while these concerns are legitimate, they are obscuring an improving economic backdrop. Confidence indicators published in July and August suggest the short term economic impact of the Brexit vote may be more limited than initially feared. In addition, Europe is benefiting from improving domestic demand, supported by falling unemployment, low inflation, rising credit supply and favourable interest rates. EU member states and the European Commission are also aiming to adopt more expansionary fiscal policies. Combined with new credit easing by the European Central Bank (ECB), all of these factors should continue to support growth in Europe.
• As an investor, it is essential to look through the political noise to see that the economic environment is improving in the region. While uncertainty is expected to persist, European financial markets still offer a number of attractions to investors, namely attractive valuations and dividend yields in the equity space, and both riskadjusted returns and support from the ECB in fixed income markets.
INTRODUCTION: KEEPING THE FAITH WITH EUROPE
In the last few years, Europe had been one of the market’s favourite regions. Global investors had hoped that the economic recovery in the region, fuelled by accommodative monetary policy and a competitive currency, would be reflected sooner or later in company earnings and thus allow European markets to catch up compared to other major developed markets, such as the United States.
However, since the beginning of 2016, it seems that many investors have lost that hope, or at least their patience, with European equities suffering seven consecutive months of outflows since February 2016 and most asset allocation surveys showing that Europe is no longer the preferred market for investors.
It is true that concerns have increased since the beginning of the year, whether over low inflation, the problems faced by the banking sector, anaemic corporate earnings growth, or the impact of Brexit. However, while these concerns are legitimate, they often obscure the underlying economic reality, which is much more encouraging. We pointed this out last year in our publication “Europe’s recovery: From caterpillar to butterfly” and we remain convinced that, despite Brexit, the European economic recovery will continue to offer many opportunities in both the equity and bond markets for long-term investors.
EUROPE’S RECOVERY BEFORE THE UK REFERENDUM
Despite the uncertainties surrounding the UK referendum, the European economy recorded its 13th consecutive quarter of positive growth in the second quarter of 2016. Growth has certainly slowed from the first quarter of the year, reaching 0.3% against 0.6% previously, but this was nevertheless in line with the average since 2000, which is 0.25% (Exhibit 1).
While the fears caused by Brexit probably weighed on growth, the impact has been very limited. Moreover, it seems that the real reasons for the observed slowdown in the second quarter are to be found elsewhere. Although many European countries have recorded a sound economic performance-such as Spain, the Netherlands and Germany, which posted growth of 0.7%, 0.6% and 0.4% respectively-the French and Italian economies,
Europe’s second and third largest, saw their economies stagnate in the second quarter. In the case of France, the reason is known. The French government’s desire to reform French labour laws to make the labour market more flexible triggered a major strike that hindered the country for several weeks.
Besides the generally robust GDP growth figures, most economic indicators published in the second quarter proved better than expected. As illustrated by Citigroup’s economic surprise indicator, data continued to surprise on the upside early in the third quarter (Exhibit 2), as the index reached its highest level of the year at the beginning of August.
While these growth figures generally should be welcomed, the second-quarter GDP growth rates were registered before the UK’s referendum, the result of which has plunged Europe into a new period of uncertainty that could take some time to resolve, particularly given the lack of urgency shown by the British government to start Brexit negotiations.
It is difficult at this stage to quantify the potential impact of Brexit because it will depend on the nature of negotiations between the UK and Europe. Both parties are probably ready to make concessions as the stakes are high, but they are higher for some than others. While the UK is likely to want to maintain access to the EU’s internal market for its services and financial industries, EU exports to the UK accounted for only 2.2% of EU GDP in 2015.
The negotiations will likely be difficult, however, because a specific statute to govern the future relationship between the UK and Europe will probably have to be created. The conditions for domestic market access applied to countries such as Norway and Switzerland-two countries often cited by the Brexit camp- do not seem applicable since they presuppose that the UK accepts a certain level of free movement of workers and a contribution to the EU budget, two points which areunacceptable to many Brexit supporters.
THE EUROPEAN RECOVERY AFTER 23 JUNE
While it is still difficult to estimate the real impact of Brexit on the European economy, this does not prevent us from analysing whether the economic upturn will continue in Europe in the coming quarters, on the basis of what we already know.
1. The impact of the Brexit vote on sentiment has so far been relatively limited
As illustrated by the evolution of sentiment indicators for European economic factors-companies and individuals- published in July and August, the impact of the referendum outcome was more limited than what one might have feared. Based on these leading economic indicators, we can reasonably estimate that Europe should continue to grow at a weak butpositive pace in the coming months.
In addition, although the political agenda remains very important in the next few months in Europe, Brexit seems not to have led so far to comparable developments in Europe. In the first post-Brexit election that took place in Spain, populist parties did not benefit from the outcome of the UK referendum. Other important political results are on the horizon, such as the referendum in Italy and the French presidential elections, but so far there has not been a large increase in anti-EU sentiment, either in the voting results or in the opinion polls.
2. Monetary policy is still supportive for asset prices and lending
The measures taken by the ECB are bearing fruit. Besides the support the central bank has provided to economic growth, weare also seeing a stabilisation of underlying core inflation and a slight recovery in headline inflation. These price trends should continue thanks to the rebound in the oil price since the beginning of the year and the growth of monetary aggregates directly induced by monetary policy
The growth of monetary aggregates (M3) also shows that the latest measures taken by the ECB, such as quantitative easing,the new targeted longer-term refinancing operations, and the Corporate Sector Purchase Programme, are all helping to improve the transmission of monetary policy. Furthermore, bank lending to individuals and companies is picking up again (Exhibit 3).
In addition to an increased volume of bank loans, we can also see that financing conditions are improving for both bank loans and on the bond markets.
In this regard it is interesting to note that the corporate bond purchasing programme is progressing according to expectations. The ECB has already bought bonds worth EUR 17.8 billion since 10 June and as a consequence 14% of European corporate bonds are now trading at a negative yield, compared with only 2% in June (Exhibit 4).
3. The European banking sector has strengthened
A strong banking sector is a necessary condition for a sustained recovery in Europe because it is a key link in the transmission of monetary policy by providing loans to companies and households.
The strength of the European banking sector, especially in Italy, has recently been questioned by investors and the MSCI EMU Financials Index is down more than 20% since the beginning of the year, despite a summer rebound.
The European banking industry is facing many challenges. The most important one is its ability to maintain profitability in an environment of low interest rates and growing regulation, but the fears of investors with regard to the viability of the sector are exaggerated.
This was implicitly confirmed by the European Banking Association stress tests, the results of which were published at the beginning of August and involved 51 banks in 15 countries representing 70% of the total capitalisation of the sector.
In the light of these stress tests it appears that the number of non-performing loans continues to grow in Italy, but this is not the case in the rest of Europe where the number seems to be trending downwards (Exhibit 5).
Moreover, the soundness of the banking sector, as measured through the Common Equity Tier 1 ratio, has improved in all European countries (Exhibit 6) and has averaged 13.2%, which is 200 basis points (bps) higher than in 2014 and 400bps higher than in 2011.
So, the European banking sector is stronger than investors had originally thought earlier this year and market performance has partly confirmed this realisation. European financials have outperformed in the late summer months and the bond markets seem to be convinced again. After falling sharply in February, bank subordinated debt indices have recently returned to positive territory. The growth of bank lending in Europe also shows that the banking sector is still able to support the recovery in Europe.
4. The austerity chapter is closed and from now on fiscal policy should support growth again
The debt crisis that erupted in Europe in late 2009 forced most EU member states to implement austerity measures, which helped to reduce public deficits and debt, but also weighed on growth. However, since 2012, public expenditure has been rising again, which should support growth.
In addition, member states are not the only ones implementing more expansionary fiscal policies. Since 2015 the European Commission has launched an ambitious “Investment Plan for Europe”, amounting EUR 315 billion, which equals 2.3% of current EU GDP3. This plan was met with some criticism when launched, but has been better received as of late, now that 115.7 billion euros of investments have been approved. The program will now be extended beyond its original term.
MARKET OPPORTUNITIES AND PROSPECTS
Regardless of Brexit, Europe’s economic recovery looks set to continue and this should be fundamentally positive for asset markets in the region.
Among developed markets, Europe is distinguished by its attractive valuation, with a cyclically-adjusted price-to-earnings ratio currently standing at 14.7x, compared to 17.8x on average since 1980. The very limited recovery in earnings in the eurozone since the crisis compares unfavourably with the US but does provide a great deal of potential upside (Exhibit 8). While current US earnings are just 1.6% below their maximum since 2000, current eurozone earnings are now a staggering 105% below their previous peak.
Despite improving economic conditions headline European earnings growth remains elusive. With 88% of the market cap reported it looks like European earnings contracted by 6.2% (year on year) in the second quarter of 2016. Although the headline number makes for grim reading, much of the negative news comes from two sectors-energy and financials. These two sectors account for over 25% of the pan-European market cap and therefore they are having a distorting impact on the headline earnings number. There are sectors showing signs of promise, with consumer discretionary and healthcare recording earnings growth of 10% and 7% respectively in the second quarter. Furthermore, the improved economic momentum in Europe, together with the continued credit impulse provided by the ECB, should support earnings growth going forward.
The key for investors is active management, in order to increase exposure to the good news stories in European markets and to try to avoid the poor performing sectors, such as financials. While waiting for corporate earnings growth to materialize, in the short term investors can still pick up a generous 3.6% dividend yield (MSCI Europe), which in these times of low returns on most asset classes remains quite attractive.
Unlike in equity markets, bond market valuations are clearly less attractive than they were a few years ago. The search for yield, coupled with the ECB’s bond purchases, have pushed bond valuations to levels never seen before. In the eurozone today, nearly 50% of government bonds and 14% of investment grade corporate bonds are trading at negative yields.
These high valuations do not mean there are no longer any opportunities. Bond markets should in fact remain influenced by the ECB’s monetary policy, which is swallowing up some parts of the bond market. Specifically, in the sovereign bond space, we believe that the environment remains supportive for peripheral bonds, which continue to trade at a higher spread to Germany than before the crisis. While we acknowledge that the crisis has left scars on peripheral bonds in the form of a higher risk premium, spreads should still at least converge towards historical averages, which include the crisis period.
In the corporate bond space, the ECB has already purchased 4% of the eligible assets as part of its Corporate Sector Purchase Programme (CSPP), which started only three months ago (Exhibit 9). This is forcing investors to consider assets that are non-eligible for the ECB’s programme, such as bank debt or high yield bonds. The ECB’s purchases are likely to continue beyond March 2017 and will have an impact both on eligible assets for the ECB as well as non-eligible assets, such as high yields bonds (Exhibit 10).
Therefore, we continue to see value in several segments of European corporate bond markets, such as European high yield bonds, which currently offer a yield of 4%, while the default rate of 1.3% remains well below to the historical average of 4.8%.
IMPLICATIONS FOR INVESTORS
The political and economic future of Europe remains uncertain but this has been the case throughout all stages of the European project. Besides, what other major global economy today can claim to provide more certainty in political and economic terms?
Paradoxically, the outcome of the UK referendum has awakened some support in Europe for the union, both from its citizens and from its politicians, with Angela Merkel, Francois Hollande and Matteo Renzi agreeing further initiatives this summer to give Europe new momentum. So, despite the result of the referendum economic sentiment has remained relatively stable and the European economy should therefore probably continue to grow in the coming quarters.
Despite the uncertainties, this broadly favourable economic outlook should support European financial markets, which are also being boosted directly and indirectly by the monetary, fiscal and structural reform measures taken in Europe in recent years. Therefore, assuming the US and broader global recovery remains on track, we believe European financial markets continue to provide attractive long-term upside potential.
Originally published by J.P.Morgan
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