Nicolas Simar, head of equity value boutique, ING Investment Management
European and eurozone equities are cheap. Everyone agrees on this. The cyclically adjusted PE ratio is at a 40 year low in Europe and the 30 per cent discount versus the US market on the same metric is substantially higher than the 10-15 per cent long term average European discount.
Besides this, while US earnings are 20 per cent above previous 2007 cycle peak, European earnings remain 30 per cent below that same cycle peak, leaving ample room for European earnings to close the gap.
Although European equities are currently cheap, they are not valued equally attractive. On the one hand, more internationally exposed ‘secure consumer assets’ (consumer staples and durables), have been rerated significantly over the last five years because of investors’ search for secure and stable growth assets. The rerating of this side of the market has pushed its relative valuation close to a 20 year high – with little value left.
However, on the other hand, companies which are more exposed to the eurozone suffered an important derating having been impacted by the eurozone and sovereign disaster that followed the 2008 financial crisis.
As a result of these trends, the eurozone’s valuation dispersion has risen to a 15 year high, leaving the value side of the markets at highly cheap valuation levels. European financials, domestically exposed cyclical companies trading at trough multiples offer significant undervaluation.
However, ECB President Draghi’s speech in the summer of last year removed, or at least reduced eurozone tail risk significantly and was a necessary condition to make the eurozone viable again for international investors.
In order to reverse the 30 per cent plus European value/growth gap that has been created over the last five years, more is needed. Besides the Eurozone’s tail risk reduction, positive earnings momentum and GDP stabilisation across the region are required.
Improved recent macro data in Europe, including rising PMIs in the periphery, do show that the Eurozone has left the recession phase of its cycle. As Europe is in the early stage of a recovery, a 1.5 per cent GDP growth next year can easily support a 10-15 per cent earnings growth in 2014.
In short, attractive valuation, improved eurozone macro data and positive earnings revision leave plenty upside room for the value side in Europe.
Britta Weidenbach, head of European large-cap equities, Deutsche Asset & Wealth Management.
The Eurozone is on the road to recovery and the recession is over. There is significant key data to support this: economic output is improving; consumer trust and especially the procurement manager indices are on the rise.
This indicates that companies’ profits will soon follow suit. Corporate cash positions in the Eurozone are higher than ever before. Profits however remain at around 40 per cent below previous peaks.
Equities stand to benefit not least because of improving macroeconomic factors couples with the European Central Bank’s relaxed monetary policy. They are also extremely attractively priced. As such, the cyclically adjusted Price/Earnings Ratio, the Shiller P/E, stands at 34 per cent under the historical average, with the absolute P/E at ten per cent.
Indeed, in comparison to the USA, Price/Earnings Ratios are at historic lows. At 3.3 per cent, dividend returns in the Eurozone are very attractive in comparison to bonds. We currently recommend overweighting Eurozone titles. In terms of sectors, we recommend financial stocks, as well as industrials and construction.
Balance of payments figures for most Euro countries have improved considerably. The constraints on economic growth caused by austerity measures are lessening. The progress made by Spain is especially noteworthy. The country has enhanced its competitiveness considerably, and indeed its balance of trade deficit has reduced. Foreign investors are increasingly committing to Spain. The Eurozone economy is improving.”
The European Central Bank announced that it would continue its low interest policy for some considerable time. This should provide additional growth impetus – for business, consumption and the equity markets. Similarly, the policy pursued by the US Federal Reserve remains positive for the equity markets. Inflation should stabilize at its current level of 1.6 per cent.
Martin Skanberg, European equities fund manager, Schroders
As well as looking good value when compared to other regions, European equities are also trading on attractive valuations relative to history. Some of the more defensive areas of the market, such as consumer staples, have become expensive as a result of the search for safe havens and dividend yield. By contrast, certain sectors – including telecoms, financials and utilities – are trading well below their historical average P/E ratios
There are many companies across Europe that have taken the opportunity over the past few years to cut costs and restructure their businesses, and thus face the future in good shape. In particular, those companies with strong, market-leading franchises in their domestic markets are well-placed to benefit from the nascent economic recovery. In addition, Europe is home to some unique assets – for example, in the luxury goods sector – which investors would not be able to replicate in other regions.
The cheap valuations in Europe currently are a reflection of how depressed earnings have been. European equity earnings are still 40 per cent below their 2006 peak and expectations remain very low, particularly in contrast to the US where forward earnings expectations have already surpassed their previous peak.
The sector where earnings have been most depressed in Europe is financials, which in turn now looks set to enjoy the strongest earnings growth. As European GDP grows and sales recover, we will see an acceleration of earnings momentum in Europe. The earnings gap with the US should start to close and there is the prospect that Europe could reach a new earnings peak in 2016.
Sectors such as financials, energy and telecoms are poised to lead this earnings recovery, as they have been most structurally challenged. As well as top-line growth coming from a re-acceleration of GDP growth, improvements in funding rates should feed through to profit margin expansion.
Clearly, Europe is still grappling with the effects of the crisis and high unemployment in several countries remains a real cause for concern.
One remaining area of risk is the credit cycle which has not turned yet. This is partly due to weak demand but also to lack of supply, as banks shrink their loan books. While GDP has stabilised, we would need to see a sustainable turn in the credit cycle to push GDP growth higher. According to the European Central Bank, demand for credit is on the rise. This is a situation that we will continue to monitor.
The European Central Bank has pledged to keep monetary policy accommodative, but external risks remain a threat.
While the Federal Reserve decided against tapering its quantitative easing programme in September, when it does happen its impact will be felt in Europe too. Nonetheless, we feel that these risks are well-known and are outweighed by the potential rewards available.