Yes, but the amount of outperformance could be limited, and growing macro-driven volatility will likely cap the absolute level of returns. Going into 2016, Eurozone stocks featured valuations in line with historical averages and an earnings cycle in an earlier stage; the weak euro and falling borrowing costs were expected to provide an additional boost. In contrast, US equities again seemed set to underperform; despite a flat 2015 return, valuations remained elevated and factors like the stronger dollar and stretched margins were potential headwinds to earnings. Roughly three months into the year, the potential drivers of Eurozone relative performance mostly remain in place. However, macro risks are rising and a few recent developments diminish the prospects for solid absolute returns.
After suffering a steep drawdown to start the year, Eurozone equities have rebounded but still lag global peers. Through March 18 they have returned -5.6% year-to-date, trailing both developed world (-2.2%) and emerging markets equivalents (2.5%) in local currency terms. Rationalizing this underperformance is perplexing—local macro and fundamental data do not seem the main drivers. Eurozone GDP growth estimates have held up better than most peers; after expanding at a slightly better than expected 1.6% (annualized) pace in the fourth quarter, the consensus expects GDP to grow by 1.6% in 2016. The February Eurozone composite purchasing managers index (PMI) at 53.0 also looked healthy, and was well above the 50.0 seen in the United States. Eurozone earnings did disappoint last year, growing just 5% versus expectations of low-teens growth as recently as last summer. Still, US earnings were basically flat last year, and in 2016 expected Eurozone growth of 8% remains above that seen in regions like the United States (2%).
Analysts seem increasingly concerned by headwinds being generated offshore, including slowing growth in China capping export demand, commodity prices remaining lower for longer, and a widening of credit spreads that could create refinancing issues for highly leveraged companies. Global PMIs have dipped sharply since January and global growth estimates have been trimmed, especially in emerging markets. Meanwhile, rising financial market stress could become self-fulfilling and also has impacted sentiment.
Responding to the weaker global backdrop and local deflationary pressures, in early March the European Central Bank (ECB) announced a new set of measures to boost inflation and growth, which included taking its key deposit rate further into negative territory, expanding its asset purchases to include non-financial investment-grade corporate bonds, and extending liquidity on attractive terms to Eurozone banks. These measures may represent a change of strategy—the ECB now seems less inclined to use an inexpensive currency to try to boost growth. Further, despite cutting rates, ECB President Mario Draghi expressed reservations about the impact of negative rates on banks and suggested this would factor into future decisions. Suspecting this marked a pause (if not a change) in policy, investors pushed the euro higher against the US dollar, and year-to-date it has now strengthened by 4%.
We do not see why concerns such as cheaper oil and rising energy company defaults should have a disproportionate impact on Eurozone companies. If anything, Eurozone companies and investors are less exposed to the oil collapse than US peers, and Eurozone credit markets are now being directly stabilized by the ECB. Eurozone companies are more reliant than US peers on sales to China, but our base case is not for a “hard landing,” as some parts of the Chinese economy are faring relatively well. Certain concerns are more valid: the stronger euro is likely at the margin to hurt earnings, negative interest rates have weakened hopes for bank profits, and thorny political situations such as immigration, “Brexit,” and determining the right monetary policy across the region are not likely to fade. On balance, the conditions for outperformance of Eurozone vs US equities remain in place, though investors may need to prepare for returns on an absolute basis that are disappointing in both markets.
Wade O’Brien is a Managing Director on Cambridge Associates’ Global Investment Research team.
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