Schroders’ Martin Skanberg reviews the next phase for European equities
European Equities Fund Manager, Martin Skanberg has outlined his views on the next developments in the European equity asset class.
Europe has started to show signs of economic recovery at a time when investors have become increasingly aware of the investment opportunities available in the region.
Some risks clearly still remain, but we would argue that the pickup in economic
activity is sustainable and that there are still further gains to come for European
Key to this will be an improvement in the credit cycle and a return to positive
Re-rating of European shares
European shares have enjoyed a re-rating since summer 2012, when European Central Bank president Mario Draghi made his pledge to do ‘whatever it takes’ to preserve the euro.
This restored investor confidence and saw eurozone shares start to recover some of the ground lost in the crisis.
The improved economic picture this year has also encouraged investors to return to eurozone equities. The region has emerged from recession, posting growth of 0.3% for the second quarter, and the recovery is starting to gain traction even in the eurozone’s troubled periphery, with Purchasing Managers’
Index surveys recently returning to expansion territory in Spain and Italy.
However, even though more investors have started to realise the potential opportunities on offer in the region, it remains the case that European equities
are still cheap compared with both their own history and when compared to US or Asian equities.
In this sense, we can say that Europe is the last of the value equity trades.
The question remains as to whether the European economic recovery is sustainable. Europe is now past the point of peak austerity and has made great progress in restoring current account balances. Competitiveness has also improved, with unit labour costs converging across the single currency area.
Nonetheless, some tail risks remain, such as high debt-to-GDP ratios, especially in the periphery. The final piece of the puzzle is liquidity, which is yet to be
restored in Europe. It will be difficult to have sustainable GDP growth in Europe
without companies having easier access to credit.
Credit conditions remain tough in the eurozone, although the broader M3 measure of money supply is in growth mode. In particular, companies operating in the periphery continue to be charged much higher rates of interest than their ‘core Europe’ counterparts, making them quite hesitant to hire new workers and expand capacity. However, there are some early signs that the gap is starting to narrow and the European Central Bank’s bank lending survey indicates that lending to corporates should pick up in the second half of 2013.
Even so, the timing of the upturn in the credit cycle remains the biggest risk
Earnings momentum yet to turn positive
Investors still have concerns over corporate earnings in Europe. It is certainly the case that earnings expectations in Europe are lower than in the US – indeed,
2013 is on course to be the third year of negative earnings momentum.
To a large extent, we can attribute the earnings gap between the US and Europe to the credit cycle. The gap emerged in mid-2011 as the US implemented quantitative easing, which increased the availability of credit and lowered the cost, while Europe embarked on austerity measures which tightened the availability and cost of credit.
Europe’s austerity headwinds are now easing and the region has returned to
positive GDP growth. This could set the stage for significant growth in earnings per share (EPS) in 2014, led by the banks and cyclical stocks whose earnings
were most depressed in the downturn.
European banks are now investible One factor that has seen some investors shy away from Europe is the fear of further problems in the banking sector.
However, Europe has taken measures to support its banks, notably via the European Central Bank’s two LTROs (long-term refinancing operations). In
dividual banks have taken steps to address capital shortfall issues, with the result that the sector as a whole is reasonably well-capitalised.
Only a few banks now screen as falling short of the latest capital requirements.
Moreover, where banks do require extra capital, we can now be more certain that it will be raised, whether from private investors, or governments, or from the European Central Bank in its role as the lender of last resort.
Capital shortfall is now a stock-specific issue, rather than a sector-wide one. In terms of funding, it will be interesting to see if there is another LTRO by the European Central Bank, and to what extent banks take up the funding on offer.
In order to restore the market’s confidence more fully, we would need to see
European banks in general adopting a more diversified funding base in terms of rising deposits and more senior unsecured funding.
Certainly there are some risks still facing the sector. The most important of these perhaps is the level of provisioning by Spanish banks for their exposure to real estate developers. In some cases, the uncovered developer exposure
exceeds the bank’s market capitalisation. This is an important risk, but a containable one. The European Central Bank is undertaking an asset quality review and stress test of banks in 2014. This may prove challenging for certain banks, but should result in improved market confidence for the sector as a whole the hunt for value.