Is Europe finally leaving the bears in the dust?
It appears investor sentiment is finally starting to catch up with reality in Europe, with the region in the middle of its biggest stock rally in five years.
Benchmark gauges across Europe make up the top 11 of 24 developed markets this year, with Denmark, Portugal and Germany posting rallies of more than 20 percent.
The Stoxx Europe 600 Index is at its highest since 2000, having surpassed its June 2007 peak.
Even the UK Index, which is held back by its weighting to suffering oil and gas companies, is up 7 per cent for the year and the FTSE 100 recently powered above the 7,000 threshold.
Backing the rally, net new inflows into Europe have been brisk to say the least – investors have pumped a record $36bn into European equities year to date.
Perhaps then it is an understatement to say that investors are finally starting to recognise that a powerful cadre of forces have aligned in support of European equities. But is all the hype just a reaction to the ECB firing the starting gun on its massive QE program, or is it a sign of a secular sea change?
We would argue the latter. It is worth considering the various signals that point collectively in the same direction, to help understand why the sentiment tides seem to be turning so definitely.
First, deflation fears have troughed. If we look at eurozone breakeven rates, or the difference between the yields of conventional and inflation-linked government bonds, we can see that inflation expectations are recovering from a very low base, albeit modestly.
Second, eurozone money supply improvement has been rapid and powerful. Regarded as an important barometer of inflation (and recent growth supports our first argument), growing money supply also indicates liquidity building up in households and companies – it’s a sign that the business cycle is strengthening.
Third, credit is expanding and flowing more freely — not only are banks making it easier to access bank lending, but demand for loans from both households and businesses is on the rise. We got the latest evidence of this recently, when the ECB reported stronger participation from banks in targeted loans (TLTROs). The take-up signals that banks are more willing to lock in long-term central-bank cash to fund loans as the economic outlook improves. In other words, it suggests future bank lending could continue to improve in a self-reinforcing way, in turn further strengthening the economy.
Fourth, and perhaps more important than any of the previous, a strong spate of eurozone economic data continues to exceed expectations, leading analysts and policymakers to upgrade their estimates for GDP growth. The solid evidence accumulating of a turn in the euro area’s growth momentum has come as a surprise to investors, helping to fuel the market rally. The growth in eurozone services and manufacturing industries, as measured by PMIs, has recently reached a seven month high.
If those positives aren’t enough to turn you into an optimist on Europe, consider that eurozone retail sales are growing at their fastest rate in more than a decade – unemployment is now falling, and real wages are on the rise. These rising tides helped corporate profits exceed expectations in the Q4 earnings season (median stocks grew earnings by a whopping 14 per cent) and saw companies raising their guidance for the third quarter in a row.
Not to be overlooked, the overall picture of the recovery is also starting to look more assured. Italy and France have embarked on much needed and important structural reform, while it is increasingly clear that those countries which already went through the painful reform process are now benefitting from the fastest growth (Ireland, Portugal and Spain).
Given this litany of positive catalysts, investors could be forgiven for wondering if the nascent European rally is already overvalued and overhyped. We don’t think so.
Current year valuations are testing, but earnings have only just started to grow. Cyclically-adjusted valuations are still below their average of the last 35 years. Relative to cash, sovereigns and corporates, European equity has never been so attractively valued. For example, compare dividend yields of approximately 3.1 percent on European equities with a sovereign bond market where negative yielding debt accounts for nearly a quarter. And while the clip of current inflows into Europe may be rapid, consider that flows are only just starting to reverse cumulative outflows since 2010.
Certainly there are risks. It’s possible that any number of shocks could derail the recovery, including an escalation of tensions in Ukraine and the Baltic states, further escalation in Greece’s debt negotiations, an erosion of current confidence meaning a delay to the cyclical upturn, such as we saw last summer when the sanctions on Russia started to bite, or even significant volatility in the bond markets as the Fed charts a path back to policy normalisation.
These scenarios are not impossible. As long as the upturn remains intact, and as long as lead indicators continue to point to further strong earnings growth this year, we would see any set-backs as opportunities to buy.
Stephen Macklow-Smith is head of Strategy for European Equities at JP Morgan Asset Management