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European equities are punching below their weight

European equities are punching below their weight

09-05-2017 | Monthly outlook

Stocks in Europe are surprisingly unloved, despite a strong earnings season which has raised their relative attractiveness versus the US.

  • Lukas Daalder
    Lukas
    Daalder
    Former CIO Robeco Investment Solutions. Daalder left Robeco in July 2018.

Speed read

  • European companies enjoyed a 26% rise in Q1 earnings
  • Stock indices have not followed suit, unlike in US
  • Risks remain though due to Brexit and slowdown threat

He says that while US stock markets have risen higher than the underlying earnings would warrant, European stocks have not kept pace with the rise in company profits in the opening three months of 2017. Instead, investors have focused on gloomier issues such as the Brexit and fears over populism.

It means that US equities are “priced for perfection” while European stocks are “priced for depression”, says Daalder, Chief Investment Officer of Robeco Investment Solutions. Subsequently, his multi-asset fund is currently overweight European equities compared with the US, though he refrains from blindly chasing stocks, as risks remain.

“On equities, we are certainly pleased with the earnings that have been reported for the first quarter,” he says. “The profits of S&P 500 companies are on track to rise by 13% versus last year, which falls short of the 15% rise seen in the S&P 500 during that same timeframe.”

“The STOXX Europe 600 by comparison is on track to record a 26% year-on-year increase in earnings per share, compared to a rise in the stock market of ‘only’ 13%. Looking at the less diversified Eurostoxx 50 (which excludes UK stocks), the numbers are 20% and 17% respectively. Based on these numbers it is clear that US stock markets have been supported by rising price/earnings multiples, whereas European stocks have become cheaper.”

Priced for perfection meets priced for depression. Source: Robeco & Datastream

Four factors favoring Europe

Daalder says the main reason for this is that the US market seems to have “priced in a lot of good news and ignored uncertainties, whereas the European market has done the exact opposite: priced in all the uncertainties and ignored all the good news.” He says there are four factors that explain why Europe is the better option right now.

  • Economic performance. “When people talk about Europe, they usually think of a sickly, overtaxed and ageing economy that is doomed to sink into oblivion. In fact, the Eurozone economy has been expanding by the same amount as the US for two years now. As population growth in Europe is below that of the US, it means that GDP per capita growth has in fact been higher.”

  • Politics. “One of the key risks flagged for 2017 was the high level of political uncertainty in Europe. The Dutch, French and German elections, combined with uncertainty with respect to Brexit, Italy and Greece, made 2017 look like a political minefield. Five months into the new year and things look a whole lot less threatening, especially with the landslide election of Macron as President of France.”

  • Revenue growth. “The first quarter is on track to be the strongest for revenue growth in over five years, with Europe potentially even reporting double-digit sales growth. Not surprisingly, this translates into strong double-digit EPS growth across the globe, with the European market taking the lead on a year-on-year basis.”

  • Valuation. “Depending on which valuation measure you use, European stocks range from being 5% overvalued relative to US equities to 48% undervalued (see table below). Our preferred longer-term valuation measure – the real Cyclically Adjusted Price Earnings (CAPE) – suggests a 48% discount. Whereas the US market seems to be priced for perfection, European stocks appear to be priced for depression.”
Source: Robeco, Bloomberg, MSCI

However, Daalder cautions about getting carried away: “Valuation is never a good timing indicator. Buying Europe simply because it is cheap has been a loss-making exercise for the better part of the last seven years. However, combining cheap valuation with other factors like improving economic sentiment, falling political risks and overall momentum, it can prove to be a very potent element in the investment strategy.”

Beware the party poopers

“So, is this the no-brainer trade of the year? Life is never that simple: there remain a number of potential party-poopers such as the Italian elections, the risk of economic momentum peaking, or the European Central Bank becoming more hawkish.”

“And then there is the Brexit negotiations, for which attitudes have clearly hardened in recent weeks. Part of this can be linked to UK election rhetoric against the EU, but there is no denying that the whole Brexit process is going to be painful for both parties involved. The risk of escalation of the conflict, as well as a drag on growth in the UK is clearly present.”

Sell in May, anybody?

“There is also the issue that buying European equities seems to be the consensus trade at the moment. With political risks subsiding, asset allocators have already been shifting funds towards Europe. Although this does not necessarily mean there is no upside left for Europe to outperform, we are normally cautious with respect to consensus trades: the risk/reward characteristics usually shift.”

“So we continue to be reluctant to jump on the bandwagon that has been chasing the speed limit for some time already, especially with the seasonal factor turning negative – ‘Sell in May’, anybody?”

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