European equities – where next?

George Efstathopoulos - Portfolio Manager (Photo : Fidelity International)

George Efstathopoulos - Portfolio Manager (Photo : Fidelity International)

Last year, investors were left disappointed with European equities. Investors have focused on three main reasons: negative result from Germany’s elections, Europe’s lack of significant technology exposure, and euro strength. A year on from the initial excitement then, is Europe more or less exciting?

European tailwinds

While structural concerns like a lack of technology exposure will remain, the broader opportunity set around Europe should not be ignored. The region’s undemanding valuations give companies plenty of room to re-rate if we see another bout of risk-on sentiment, with European valuations close to a ten-year low relative to the US. At the same time, the outlook for earnings is brightening. Absolute earnings revisions have moved back into positive territory for the first time in six months, with analysts now expecting corporates to do better than initially thought.

The eurozone should also see further tailwinds from higher credit growth, with banks increasingly able to focus on their day to day activities, rather than rebuilding their balance sheets from the financial crisis. The outstanding amount of non-performing loans in Europe has been falling quickly, allowing banks to set aside less capital to cover losses. Given that Europe’s economy is more credit driven compared to the US, easier credit availability should be a strong tailwind — both for the economy and corporate earnings.

While equity performance should be boosted by all this, there are also more direct supports to European markets. Share buyback growth has turned positive again — after two years — and this should persist given a combination of good growth, available credit and robust balance sheets.

The euro is not an insurmountable obstacle

This positive picture naturally leads to questions about the euro, with the currency having appreciated significantly on an improved backdrop last year. However, in both the US and Europe, markets have typically priced in monetary tightening ahead of it happening — as with the eurozone last year, or the US from 2014-2016. As the Federal Reserve continues to raise rates, some of the pressure on the euro against the US dollar should subside over the year, something we have started to see in recent weeks. 

If there is a lesson for investors from European asset performance across 2017, it is to focus on how different asset classes perform at various stages of the economic cycle. Currencies have proved to be the better way to play the earlier stages of a region’s economic recovery, with the focus switching to the equity market as recovery becomes more established. When considering Europe now, investors should also remember that the euro is not an insurmountable obstacle, with European equities having previously outperformed from 2004-07 against a strengthening euro. Given the support to the region, from valuations, economic fundamentals, and technical factors like buybacks, investors should not dismiss Europe lightly.

George Efstathopoulos
Portfolio Manager

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