European equities: The road ahead
Patrick Moonen (pictured), Senior Strategist Multi Asset at ING Investment Management (ING IM), on European equities…
It’s not clear whether a consistent positive relation exists between the average temperature on European beaches and market performance, but since the start of the summer global investors seem to look with a different eye to the European equity market. Although we must not get carried away – as one swallow does not make a spring – we think investors did rightfully become more positive on Europe.
For a starter, Europe emerged from recession in the second quarter. The improvement was broad-based with both Germany and France beating expectations. The UK from its side continues to surprise on the upside, as witnessed by rising house prices, retail sales and industrial production data. A recovery in the US and Japan, a somewhat lesser focus on fiscal austerity, easy monetary policy, and a fading of the systemic risk perceptions are at the basis of this recovery.
Second, earnings growth has … and we expect acceleration in the second half of the year and into 2014. Taken into account the high sensitivity of European earnings to even a small improvement in revenues, we expect margin expansion and double-digit earnings growth next year provided the global growth environment remains benign.
To make the picture even more compelling, this earnings growth does not come at a high price. The price earnings ratio of European companies is 15% below the global average. Relative to the US market, the discount is even 35%, which is close to historic highs. Sure, Europe – or at least the Eurozone – has some unique (economic and political) challenges in building a more stable monetary union, and these probably warrant a discount. But we doubt it should be as high as 35%.
The equities market is not only attractive relative to its peers, but also when held up against the bond market. The dividend yield on European equities is 3.6%, almost double the level on a German Bund. However, there is one important difference. A combination of tapering in the US and improving macro data will most likely drive bond yields higher, leading to a loss on the bond holdings whereas dividends have ample room to grow given the better profitability of companies and the high level of retained earnings. This is also an incentive for companies to gear up their balance sheet. Replacing expensive equity capital by cheap debt reduces the average cost of capital, lowers the hurdle rate for new investments and increases the return on equity. This must sound like music in the ears of equity investors.
They seem to have embraced the theme. There are signs that the rotation from bonds to equities may be around the corner. This will not happen overnight, yet for the first time since 2007 equity inflows have surpassed bond inflows, and more recently this trend accelerated. Whether or not this rotation will continue depends on the sustainability of the economic and corporate fundamentals. This will of course partly depend on external factors such as emerging market growth and the evolution of the oil price. However, a comforting thought is the willingness of both Draghi and Carney to keep financial conditions easy and to use whatever is in their means to reach this objective. As always, the proof of the pudding is in the eating, but we do like the ingredients.
This leaves us with the question of what to buy in Europe? We see three promising themes: Further systemic risk reduction, more investment spending and a recovery in consumption. The easiest way to get exposure to these themes is through financials, industrials and consumer discretionary.
But be prepared, the road may be up but the path is long and full of curves and potholes. As an investor in European equities you’d better have a set of good shock absorbers.
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