William Davies, Head of European Equities, Threadneedle, examines the prospects for Europe against a backdrop of austerity packages.
The difficulties facing peripheral European economies are well-documented, with austerity packages in markets such as Greece, Spain and the UK likely to subdue activity over the medium term as taxes rise and job security falls. However, the global economy is recovering and emerging markets in particular are continuing to deliver robust levels of growth. This provides a good backdrop for global demand in a number of industries.
Much has been made of the weakness of the euro, and it is certainly true that the recent problems in addressing peripheral countries’ debt problems have revealed fault lines in the single currency. However, we firmly believe that the euro will survive its current stresses, even though a period of further weakness seems likely. A weak euro is good news for the many exporters operating in the core of Europe, as it makes them more competitive on the world stage and also increases the value of their overseas earnings. We have already seen the UK benefit from this theme. Sterling was very weak on the foreign exchange markets last year and recent data on exports, as well as quarterly results from companies with international operations, have showed the positive impact that a weak currency can have.
The tailwind provided by a weak currency, together with recovering growth in core Europe and the operational gearing benefits of cost cutting undertaken during the downturn, give us confidence in the outlook for European corporate profits. We foresee aggregate earnings growth of around 25% in 2010. Much of the recent volatility in world markets has been a result of investors questioning earnings momentum into 2011. We forecast a modest slowdown compared with this year, but earnings are still expected to grow by a further 15% next year.
The forecasts outlined above should see aggregate earnings in 2011 return to 2007’s levels. Meanwhile, the market is some 40% lower today than it was at the earnings peak. As a result, valuations are looking attractive. Our forecasts place the European equity market on a PE multiple of 10.7x 2011 earnings – well below the ten-year average of 18.8x. The market is similarly attractive relative to history on other measures, such as price to book (1.6x versus a 10-year average of 2.6x) and price to cash flow (8.7x versus 10.2x). European equities also offer the most attractive yields on the global stage, with a 2010 prospective dividend yield of 3.5%, rising to 3.8% in 2011. With 10-year government bond yields at 2.6%, equities represent excellent value relative to bonds. Companies themselves are seeing the value in markets, as illustrated by an upturn in corporate activity. We expect this to remain a feature in the medium term.
We have expanded our European equity offering significantly in recent years and now provide Pan European and continental European funds investing across the capitalisation scale. The range features core, high alpha and very focused portfolios, together with an income product designed to take advantage of the high dividend yields on offer from European stocks. We have also recently introduced SICAV versions of some of our popular OEIC strategies.
We continue to underweight peripheral Europe and companies that sell into those economies. However, we believe that it is unwise to eschew these markets altogether as they feature a number of oversold companies with exposure to faster-growing overseas economies. For example, we are invested in some Spanish companies that are generatiing strong profits from their Latin American operations. In terms of sectors, we are running a balanced strategy between defensive, secular growth companies and more cyclical businesses whose earnings are geared into improving global growth, and especially strong emerging market demand. On the defensive side of the portfolio, we favour consumer staples and healthcare over telecoms and utilities – given the regulatory and competitive pressures facing the latter sectors, we see them as value traps. Our more cyclical exposure is coming primarily via mining and industrial companies; we remain cautious on financials.
Our approach to investing is based on understanding the themes driving markets, analysing the business and financial models affecting companies and marrying the two disciplines to populate portfolios with good quality stocks that are well suited to the prevailing investment conditions. This approach has proved very successful over the long term. For example, our Pan European OEIC outperformed its benchmark index in 2007, 2008 and 2009 – a rare achievement given the very different market conditions that characterised those three years. The fund is also comfortably ahead of its benchmark over the year to date and has outperformed the index by more than 20% over the past five years.
Although some European economies face major headwinds to growth in the coming quarters, the global economy continues to recover and, meanwhile, the weak euro and cost cutting undertaken during the recession are boosting earnings growth potential. Based on our forecasts, European equities are trading well below their historical averages on a number of valuation measures and are also looking very cheap relative to bonds. Our portfolios are invested with a clear strategy and our extensive range of European funds has generated impressive long-term performance. We are confident that our proven process can continue to deliver strong relative returns to our clients.
