European Equities: Time to Focus on the Micro

Europe has faded from the headlines in 2013 as Federal Reserve tapering, Abenomics in Japan, and a slowdown in China have garnered the lion’s share of investor attention. During what has been a strong year for risk assets, European equities have generated reasonable but not stellar returns; over the last several years, they have underperformed developed markets peers by a more significant margin. This has left current relative valuations near historical extremes, particularly in relation to U.S. equities. European equities also offer upside as macro conditions are improving and earnings should rise from a relatively low base. As a result, we recommend overweighting European equities relative to U.S. equities. This comment lays out the arguments for and against increasing exposure to European equities, and touches briefly on implementation considerations. Credit and sovereign bond markets are also discussed, though they offer few attractive opportunities.

European Equities

We have been neutral on European equities for some time given the difficult macro environment as well as overall valuations that are not as compelling as those in other regions like emerging markets. Mindful of various risks to the global economy and thus corporate earnings, we were also concerned that the relative discount in European equities was largely concentrated in cyclical industries. Earnings have indeed contracted and shares have underperformed those of developed markets broadly over most time horizons to date, though skilled market timers may have benefitted modestly with tactical moves.

We are more bullish now for several reasons. Absolute valuations have richened, but European equities are valued at close to a record discount relative to other developed markets equivalents (Figure 1) given underperformance over most trailing timeframes (Figure 2). Should valuations revert to their historical relationship, an investor overweight Europe and underweight U.S. equities would benefit by 30% through mean reversion alone. Low valuations offer downside protection should markets again become volatile. For example, in a worst case scenario where markets revert back to early 2009 multiples, European stocks might decline around 31% from today’s levels (from 14.0 times to 9.7 times normalized earnings per share [EPS]), while U.S. equities could drop 45% from 20.2 times to 11.1 times.

Sources: MSCI Inc., and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.
Note: The composite normalized price-earnings (P/E) is calculated by dividing the inflation-adjusted index price by the simple average of three normalized earnings metrics: ten-year average real earnings (i.e., Shiller earnings), trend-line earnings, and return on equity (ROE)–adjusted earnings. The ROE-adjusted P/E ratio is the current trailing P/E ratio multiplied by the ratio of the current level of ROE to its historical norm. Shiller P/E is calculated by dividing the current price level by the ten-year average of inflation-adjusted earnings per share. Trend-line P/E ratios compare current stock prices to the level of earnings predicted by long-term real earnings growth based on a simple linear regression.

Sources: MSCI Inc. and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.
Note: Top chart rebased to 100 on September 30, 2010; bottom chart rebased to 100 on September 30, 2012.

Another reason for our growing comfort with Europe is that the current discount in European equities is not concentrated in a handful of sectors or countries. Nearly every sector in Europe trades below its historical average price-to-book (P/B) ratio, with financials and energy offering discounts of 44% and 35%, respectively (Figure 3). Across regions, U.K. equities appear more attractively valued on an absolute basis, with a normalized composite price-earnings (P/E) ratio of 12.8, though they trade at a similar discount to historical averages compared with Europe ex U.K. Given the debt crisis and investor positioning, continental markets are widely dispersed. While some markets trade above historical norms (e.g., Switzerland at 22.5), others like France (13.5) and Spain (10.0) offer substantial discounts (Figure 4). On a global basis, emerging markets valuations are more compelling on an absolute and relative basis (Figure 5), though they face questions such as whether the recent slowdown is more cyclical or secular in nature.

Sources: FactSet Research Systems, MSCI Inc., and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.
Note: Data prior to January 31, 1995, are sourced from FactSet.

Sources: MSCI Inc. and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.
Notes: For the bottom chart, averages for Germany, Netherlands, Sweden, Switzerland, and the United Kingdom begin January 31, 1970; France begins September 30, 1971; Spain begins January 31, 1980; and Italy begins April 30, 1984. Negative earnings were removed for Italy for February 1994 through April 1994 and for March 1995. Negative earnings were removed for Sweden for April 1993 through February 1994.

Sources: MSCI Inc. and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.
Notes: To minimize the impact of bubble periods on valuations, we have excluded the years 1998–2000 from our historical average and standard deviation calculations for EAFE ex Japan, Europe, the United States, and World ex Japan. No adjustments have been made for emerging markets equities. Z-scores represent the number of standard deviations away from the historical mean.

European equities may also benefit from the potential for positive earnings surprise given the current level of earnings. European earnings as measured in local currency are down roughly 30% since fourth quarter 2007, while U.S. and emerging markets index earnings as measured in U.S. dollars are 16% and 13% higher, respectively (Figure 6). Steep declines in earnings for cyclical sectors like financials (-72%) and materials (-54%) have driven this drop, as more defensive sectors like consumer staples and health care have fared better (Figure 7). Profits could rise for several reasons. Economic growth could accelerate as the worst of the fiscal drag has passed and austerity pressures are eased. Margins at extremely depressed levels also offer room for upside—according to Barclays, European margins today are roughly 50% of the U.S. equivalent, the widest gap in over 20 years. Putting aside growth and mean reversion arguments, margins could expand as revenues increase given companies and consumers can no longer defer necessary spending—European capital expenditure and car sales are at 20+ year lows. Higher output should allow greater efficiency, while less sovereign stress could see borrowing costs fall for a variety of peripheral companies.

Sources: MSCI Inc., FactSet Research Systems, and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.
Notes: Earnings rebased to 100 on December 31, 1995. Emerging markets and U.S. data in US$ terms; European data in local currency.

Sources: MSCI Inc., FactSet Research Systems, and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.

The trend in earnings deterioration also means that forecasts have come down, lowering the bar for companies to beat. Despite earnings that sit roughly at 2006 levels, the consensus now expects a slight decline in earnings for 2013 followed by somewhat brisk 12.4% growth in 2014 (Figure 8). Focusing again on the cushion to investors if earnings disappoint, trailing 12-month European earnings have dropped 8% since March 2009, while U.S. profits have risen 79%.

Source: FactSet Research Systems.
Notes: Earnings rebased to 100 on May 31, 2012. Estimates based on a bottom-up calculation using data pulled from the FactSet Market Aggregates Estimate database.

Is it reasonable to assume European corporate profits will reverse their recent slide? The fate of the financial sector (22% of MSCI Europe market cap, Figure 9) is important. Current consensus estimates are for a fairly robust 15% rise in 2014 earnings, which would still leave them well below previous peaks, according to J.P. Morgan. The sector faces a variety of regulatory and fundamental headwinds. Many institutions have made scant progress deleveraging (Figure 10), and asset quality may yet take a turn for the worse in some countries where growth is lagging. The current regulatory focus on leverage ratios could either dilute capital raisings or force some banks to sell assets at disadvantageous prices. In late 2014, the ECB will become the regulator of the largest, most systemically important banks in Europe. As the ECB transitions to this role, it will conduct stress tests that could reveal additional bad debt or operational problems. Meanwhile, funding costs could rise for banks for several reasons. Perceptions of credit worthiness could fall as authorities seem more willing to let bank creditors take haircuts during insolvency proceedings. Bank debt issuance could also rise as inexpensive LTRO funding is replaced.

Sources: MSCI Inc. and Thomson Reuters Datastream. MSCI data provided “as is” without any express or implied warranties.
Notes: Nordics include Denmark, Finland, Norway, and Sweden. Peripherals include Greece, Ireland, Italy, Portugal, and Spain.

Sources: Bloomberg L.P. and European Central Bank.
Note: Leverage ratio is represented by total assets divided by total equity.
*Lloyds figure represents percent change from 2009 to 2012.

However, these negatives are well known and there is an upside case. Overall sector leverage remains high, but progress has been made at a number of large institutions, especially in the United Kingdom and Switzerland. The improving macro environment could see credit quality improve, and the volume of capital targeting European assets could improve prices for banks that need to dispose of assets. Capital raises might dilute earnings for some banks, but in some countries (e.g., Germany, the Netherlands, Spain), much of the sector is not publicly traded or features sizable amounts of state ownership; thus, implications for equity investors are more nuanced. Overall bank asset levels are higher in Europe (versus GDP) for various reasons, but two are of particular interest for investors. European banks hold large mortgage portfolios (whereas in the United States this financing is dominated by Fannie and Freddie), which should prove fairly stable revenue streams if macro conditions stabilize. Since some European banks also have large offshore businesses, assets/GDP comparisons may overstate deleveraging needs. In any event, banks trade at around 10 times 2014 earnings and 80% of book value, providing some cushion even if earnings disappoint or additional capital needs to be raised.

The energy sector also trades at a significant discount to global peers, given nearly two years of declining earnings, as well as various operational headwinds including litigation (BP) and risks of reaching ever farther to find new resources (Repsol, Royal Dutch Shell). However, consensus estimates are only for a 12% rebound in earnings next year. The 9 times forward earnings multiple for 2014 and the sector’s newfound focus on reduced capital expenditures and boosting cash flow create potential for upside surprise. Similarly, earnings for the materials sector are expected to grow around 20% in 2014 yet remain substantially below previous peaks, according to J.P. Morgan. Managers clearly overestimated commodity demand in recent years and overspent on capital expenditures, but the worst of the write-downs may be passing and faster global growth may boost demand while bringing revenues more in line with costs. The auto sector trades at roughly 8 times forward earnings, an extreme discount given multi-decade low auto registrations. It may take relatively little for earnings to beat muted expectations.

From a tactical perspective, while much of the sell-side has recently become more constructive on Europe, we see little evidence that investors are starting to reverse their massive underweights to the region. So far in 2013, $188 billion has poured into global equity funds, though the great majority was targeted at the United States and Japan (Figure 11). Post-Lehman, the cumulative purchases of European equities by U.S. investors were approximately zero, according to a recent Goldman Sachs report. While much could still go wrong, such extreme positioning suggests room for a bounce if earnings start to meet or beat fairly low expectations.

Sources: BofA Merrill Lynch Global Research, Credit Suisse, EPFR Global, and MSCI Inc. MSCI data provided “as is” withouth any express or implied warranties.
Notes: Market caps for specific regions and fixed income products represented by Barclays High Yield Index, Barclays Investment Grade Index, Barclays Treasuries Index, CS Leveraged Loan Index, MSCI EM, MSCI Europe, MSCI Japan and MSCI U.S.

Macro Update

The improving macro environment in Europe reinforces our more constructive view, though this is less influential than the valuations and earnings conditions. The Eurozone finally exited recession in the second quarter (Figure 12), and GDP growth in countries like the United Kingdom and Germany (both at 0.7%) compared favorably with global developed markets peers. A variety of metrics are trending upward, including purchasing manager indices, which are firmly in expansion territory in the United Kingdom and hit their highest level since June 2011 in the Eurozone (Figure 13). Unemployment has dropped steadily in the United Kingdom, and while high in the Eurozone, appears to be stabilizing. Business and consumer confidence have inflected sharply upward, albeit off low bases.

Source: Thomson Reuters Datastream.

Source: Bloomberg L.P.

Growth is receiving a tailwind as the fiscal drag from austerity fades. Some countries have put the worst of their adjustments behind them, while others have received more slack from various authorities (European Commission, ECB, etc.) to ease up on targets given negative fiscal multipliers are better understood. According to simple debt math, if each euro of spending reduction trims GDP by more than this amount, spending cuts worsen debt dynamics. The International Monetary Fund has led the academic about-face on this topic, though as growth has slowed in core countries like the Netherlands and France, their politicians (and voters) have also become more understanding.

There are encouraging signs that the periphery has used the time bought by the OMT to help rebalance economies and improve debt dynamics. Most of the peripheral countries have closed current account deficits (often by reducing imports) more rapidly than expected, helping to reduce reliance on foreign capital (Figure 14). Greece and others have made surprising progress by closing fiscal deficits, and in other cases the worst of the tightening may be over. Unit labor costs have declined across the periphery, improving competitiveness and helping countries such as Spain boost exports. Lower sovereign funding costs have improved debt sustainability, while wholesale markets have gradually thawed for most peripheral countries.

Sources: International Monetary Fund and Thomson Reuters Datastream.
Notes: Unit labor costs and export levels rebased to 100 starting in 1998. Data for 2013 are through June 30.

It could also be argued that several years into the European sovereign debt crisis, political risks have ebbed as decision makers better understand their options in dealing with the crisis. From a debtor perspective, many countries have begrudgingly come to accept that they must spend what they earn, and that debt default may offer far fewer benefits than initially seemed the case. If a country has a hard time borrowing to fund its excess spending now, decimating its reputation and credit ratings via default likely will not make it easier. Conversely, if a country can earn what it spends, and bailouts can cut interest rates to effectively zero and/or extend the maturity profile of existing debts, then why bother defaulting and suffering repercussions in the first place? Threats about countries leaving the European Union (and thus potentially losing access to institutions like the ECB) have also died down, perhaps because currency devaluation is no longer seen as the panacea it once was. Putting aside the issues with debt redenomination and technical default, weak currencies only help if a country has tradable goods. These are in short supply in countries such as Greece and Portugal; other countries like Ireland and Spain have already boosted exports simply by cutting labor costs. Political parties that proposed extreme tactics when dealing with creditors seem to have lost their luster in many instances—for example, the rapid fade from glory of the Five Star Movement in Italy. Hard choices are required, and in at least some cases voters are seeing through “easy” options.

None of this is to say that significant risks do not still exist in Europe. The OMT program has bought time and lowered borrowing costs, but it has not yet been tested. Further slippage on fiscal targets by Italy or Spain could see the markets attempt to test ECB President Mario Draghi’s resolve. European authorities have continually pulled themselves back from the brink and forged new solutions, though coalitions in many countries are fragile and politicians like Silvio Berlusconi in Italy could still play the role of spoiler. Challenges to current policy may arise from other corners—for example, the powerful Bundesbank is on record questioning the OMT’s legality.

While recent economic data show improvement, growth could again falter for a variety of reasons. Across Europe, the lack of structural reform in areas such as labor laws weighs on activity, as do high levels of taxation. Deleveraging needs are ongoing. For peripheral countries such as Greece and Portugal, additional debt restructuring seems almost inevitable, which may roil markets. Unemployment seems to be stabilizing but remains near record highs, fuelling concerns about a lost generation of idle youth and resulting political instability. Finally, while banks in some countries like the United Kingdom and Switzerland have made significant progress in trimming their balance sheets, in other countries sector leverage continues to rise and recession may mean nonperforming loans are rising. While not true for financials, the good news is that overall European debt and budget statistics compare surprisingly well with those of global peers (Figure 15).

Sources: International Monetary Fund and Thomson Reuters Datastream.
Notes: Budget surplus/deficit figures for 2013 are IMF projections. Current unemployment rates are as of June 30, 2013.

Several wildcards may impact European equity performance. Growth is slowing in many emerging markets, which may depress demand for exports of European goods and services. This would be especially problematic for those companies, like U.K. natural resource firms, heavily exposed to the region, though current valuations mitigate the problem somewhat. Competition from Japanese exporters benefitting from a cheaper yen could impact some European firms, though some sectors see little overlap and in others companies from both regions have moved manufacturing (and thus costs) abroad, reducing an advantage from currency fluctuation. Finally, shifts in global monetary policy could still throw a wrench in the works, though this arguably favors European risk assets. The Fed should begin tapering its purchases of assets before the end of 2013, but the Bank of England recently announced it would keep rates low until at least 2016 and Draghi has commented that market expectations about rate hikes were “unwarranted.”

Equity Implementation

For some time, we have suggested that investors take an active approach when investing in European equities, given the potential for macro-related volatility as well as the related high dispersion of valuations across industries and regions. Many active managers have indeed outperformed in recent years, and we continue to prefer this approach. However, will these managers that beat the index by favoring “quality stocks” and underweighting peripherals now underperform if macro data continue to improve and fears over sovereign debts die down? This risk seems mitigated for several reasons. Peripheral markets (including Spain and Italy) are less than 10% of European market cap and may make only a small contribution to index performance if they re-rate. Further, operational and regulatory issues—that will not necessarily be resolved by improving macro conditions—justify discounts for some cyclical companies. For example, capital, credit quality, and earnings potential vary significantly across the financial sector, as do valuations. Finally, notwithstanding recent improvements, we believe further macro-driven volatility cannot be ruled out and “baby being thrown out with the bathwater” situations could again provide attractive opportunities for active managers.

For investors that have the ability, we also believe that skilled long/short hedge fund managers offer an interesting way to invest in European equities as conditions have been and remain favorable. As with active long-only managers, some of the most successful long/short hedge funds in recent years have not excelled by buying inexpensive assets (periphery, banks) but rather found quality stocks in core countries where estimates were too pessimistic; in this respect, these funds may prove interesting substitutes for long-only managers targeting similar assets. We would also highlight that in recent years some global tactical funds and multi-strategy hedge funds have successfully tacked between European credit and equity investing (at times going short one while long the other), and these too remain an interesting option.

Fixed Income and Currency

While we are more optimistic about the macro environment in Europe, our fundamental views on European sovereign bonds have not changed. We consider core (German, French) sovereign bonds overvalued given that low yields limit upside potential and thus their usefulness as a deflation hedge, and think that investors should underweight these assets in favor of cash. While the resulting negative real returns may be unappealing, inflation is fairly contained and higher growth (or political pressure) could lead to rising rates, justifying this trade-off. With respect to peripheral sovereign bonds, we believe investor upside is somewhat asymmetric for several reasons. Current peripheral yields are suppressed by the threat of OMT and idiosyncratic issues such as demand from local peripheral banks driven in part by regulatory pressure. Yields could rise under a variety of scenarios—for example, if troika negotiations fall through for bailout recipients or the ECB prove unwilling or unable to follow through on its promises. While some fund managers might successfully navigate such events, the potential volatility of these assets makes them unsuitable deflation hedges.

In a similar vein, while we believe a better macro environment has positive implications for corporate earnings and balance sheets, yields near record lows make euro-denominated investment-grade bonds very overvalued. In recent years, returns on such assets have exceeded expectations as yields collapsed and defaults remained limited. However, year-to-date returns have been essentially flat as the slight backup in yields has almost exactly offset the carry. Technicals remain favorable for the asset class as net issuance continues to shrink, driven by reduced bank issuance. Still, with index yields of around 2.2% on offer, we believe investors are better served allocating to other types of diversifying assets.

Finally, no discussion of European assets would be complete without some thoughts on hedging currency exposures. The European index offers exposure to a variety of currencies, including the euro, pound, and Swiss franc. Each of these currencies has differing fundamentals and reasons for strength/weakness against other major currencies such as the U.S. dollar, which makes predicting future currency movements difficult. Our recommendation to overweight European equities at the expense of U.S. equities is not based on a view on currencies. Given that the euro appears vulnerable against a variety of currencies should sovereign debt stresses resurface, we recommend investors partially hedge currency exposure when holding or increasing exposure to European equities simply to reduce the risk that currency moves overwhelm the equity performance; this advice holds for investors with US$, GBP, or other major base currency references.

Conclusion

Macro concerns have eased in Europe, though this may prove temporary, and growth seems to have returned, if only at a moderate pace. Earnings have continued to decline, but may be bottoming given better growth and pent-up demand. The bad news for equity investors is that some of this is priced in, and European equities may no longer be the bargain they were on an absolute basis 12 months ago. However, European equities are more attractive on a relative basis, and should offer greater upside if earnings can stabilize and eventually beat fairly muted expectations. While far from guaranteed, the tactical case would be enhanced if investors underweight the asset class start to increase allocations. Wildcards for European equities include politics, global growth, and fiscal policy, as well as the fate of the region’s banks. However, the unknowns seem to be decreasing. Events like the German elections are behind us, and we have seen that bank deleveraging can occur in a somewhat orderly fashion given the experience in countries like the United Kingdom and Switzerland.

The relative valuation discount of Euopean equities is quite compelling even taking into account the potential risks. We recommend an overweight relative to the United States, which is the most expensive developed market.