A combination of factors suggests to us that 2011 will be a good year for European equities. Looking at the economic fundamentals, we accept that the peripheral countries of Europe face significant economic uncertainty, but we expect the core European recovery to continue through 2011.
Furthermore, corporate profitability and cash generation is strong, given a period of excellent cost management during the downturn. Finally, valuations in the context of historic ranges versus other equity markets around the world and, most importantly, versus many other asset classes, look highly attractive.
But what about the sovereign debt crisis?
Deficit issues
Peripheral eurozone sovereign debt loads have garnered a lot of press, with recent concerns about the stability of Ireland’s economy only serving to stoke the fire. However, the country’s austerity measures have shown signs of promise and, if we look across the other peripheral European countries, national governments seem determined to address public debt. In addition, core Europe has demonstrated the political will to support weaker members. There remain considerable uncertainties ahead, but we should remember that peripheral Europe accounts for only 17% of eurozone GDP, which leaves vast opportunities elsewhere in which to invest. Many of these opportunities have good exposure to emerging market growth without the frothy valuations.
Let’s examine why we feel now is a good time to invest
European economic fundamentals remain supportive
The macroeconomic environment continues to provide signs of encouragement, as broad-based indicators of economic activity remain supportive. Latest indicators reveal industrial producer prices are up 0.3% in the eurozone from August to September, and new industrial orders are up by 5.3% from July to August. Most recently, the German and French economies have shown economic growth of 0.7% and 0.3% respectively in 3Q.
Employment trends have started to improve
With unemployment growth and labour rigidity looking like potential headwinds a year ago, the expectation in recent months for lower unemployment across Europe (with the exception of Portugal and Greece) has been an encouraging trend. For instance, October official labour office figures revealed that unemployment in Germany had fallen to levels not seen in 18 years. If we take Germany as an example in practice, the flexible working conditions adopted in the labour market look to have helped drive down unemployment, and also increase productivity. In fact, since reunification, there have been dramatic productivity improvements in Germany, and we believe this could support a stronger consumer environment and drive growth in consumer expenditure going forwards.
…and consumer confidence looks to be stabilising
Admittedly, there is a geographical divergence in consumer confidence across Europe — effectively a north/south divide. Recent data would suggest that the two most robust consumer environments are in Germany and Sweden. Both countries have a very different fiscal backdrop to the rest of Europe. This is notable when comparing with peripheral countries, such as Spain and Italy — where consumer confidence remains weak, but is stabilising. So, from a consumer perspective, core Europe is leading the charge.
…and what about the euro?
Of course, the weaker euro to some extent will have contributed to the strength of the macro data in core Europe with export-orientated businesses benefitting from the currency depreciation. Indeed, we saw the euro/dollar exchange rate weaken in 1HFY10, from highs hovering around the US$1.50 mark to down below US$1.20.
However, it is worth noting that European companies have been competing effectively on a higher average euro/dollar rate of US$1.40 for the past four years, and despite the single currency strengthening since the lows we saw in June, current rates are still falling shy of this longer-term average. European exporters, therefore, remain better positioned than they were certainly a year ago — especially as there has been a recovery in global demand.
So, at current exchange rates, the export market continues to be a key source of demand for these companies.
Healthy corporate sector
Encouraging company earnings
We have seen robust earnings growth over the last 12 months, and we believe there is room for double-digit earnings growth in 2011, with figures still sitting below trend. If we consider the amount of cost-cutting that European companies have had to embark on over the last few years, many are now very lean businesses relative to history. As a result, we feel these companies are in a strong position — backed by a resilient economy — as we go through into 2011.
Cash-rich environment
Corporate cash flows continue to be very strong and company balance sheets are looking particularly robust. The debt-to-equity ratio for European companies right now is at 50% and is forecast to reach 20-year lows over the coming quarters. With these factors in place, we would expect an uptick in M&A activity and increasing cash returns to shareholders through dividends or buybacks. Nestlé and BHP are examples of European companies already demonstrating this trend.
Valuations remain attractive
Relative to history, European equities are still trading on very appealing multiples. If we take the one-year forward price-to-earnings ratio, there is some way to go before getting back to the average trend line over the last 20 or so years. This also applies if using 10-year average earnings — Graham & Dodd PER — which tries to strip out the volatility of the earnings. So, whether we use short-term or long-term ratios, we feel that the absolute valuations continue to look very attractive.
What about relative to other regional equity markets? European equities are trading on lower ratios than US or Asian equities. Clearly, faster growth in Asia accounts for the dispersion here, so a premium is to be expected. However, we think this gap is still too wide, as is the dispersion versus developed markets, especially the US. On this basis, Europe is definitely providing opportunities to purchase stocks at relatively attractive prices, and there is certainly room for further re-ratings in the market.
European equities compared with other asset classes? Equities are either matching, or in many cases outstripping the yield available on corporate and government bonds. For example, good quality, cash-generative European companies are currently offering dividend yields in the region of 4% versus near 2% on a 10-year German bund.
How has market behaviour affected demand for European equities? The recent characteristic volatility in risk appetite has resulted in the “polarisation” of markets, whereby investors have either been chasing growth in the riskier emerging markets or have taken the polar opposite approach and ploughed money into safe haven assets such as gold, currencies and US government bonds. We feel this polarisation will become less of a driver as investors become increasingly aware of the attractiveness of European equities versus the extremes witnessed in other areas.
…fund flows?
While it’s difficult to identify turning points, the sheer scale of inflows into developing markets and outflows from developed markets seems unsustainable — for example US$74 billion (RM232 billion) of inflows into emerging market funds this year versus US$28 billion of outflows from US mutual funds. In terms of the other asset classes, take the US bond market as an example, in 2000 the US bond and equity markets were of comparable size — today the equity market is 40% of the size of the bond market in the US.
Conclusions
Recently, economic growth has experienced a temporary slowdown after the rampant inventory rebuild of 2009. This is natural. We do not expect a double dip scenario. Rather, we expect developed economies to make a sustained recovery over the coming quarters. We accept that peripheral countries in Europe are facing substantial difficulties and it may take some time for these countries to emerge from stagnant growth as austerity measures feed through their economies. However, we believe core Europe is on a stable road to recovery, having been relatively underexposed to excess leverage. Following disciplined cost-cutting and efficiency management during the crisis, core European companies are delivering strong earnings growth and are deleveraging. In 2011, we expect companies to reinvest in their businesses and return excess cash to shareholders.
European equity market valuations remain attractive relative to other asset classes, where in some cases we see asset bubbles developing, driven by “safe haven” status and temporary global quantitative easing. In addition, European equities are also attractively valued against the US and emerging markets.
Within our portfolios we expect to benefit from:
(i) Core European growth — we maintain an allocation bias towards the growing economies of Europe; and (ii) A focus on mispriced companies which should continue to reap rewards from emerging markets structural growth.
Most important, however, is our continued search for fundamentally undervalued stocks.
The primary source of our alpha generation will be derived from first-class analysis into European companies, driven by our extensive European and global research platform. - by Rory Bateman
Rory Bateman is Head of European Equities and joined Schroders in April 2008. Prior to joining Schroders, Bateman spent 12 years at Goldman Sachs Asset Management where he was the portfolio manager for Continental European Equities for eight years. In addition, Bateman has 12 years experience as an analyst covering numerous sectors across the European market. He has a degree in Financial Economics and a postgraduate degree in Economics.
This article appeared in The Edge Financial Daily, December 16, 2010.
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