Germany: Hoping and healing

Sentiment in European equity markets swung last year, in favour of
peripheral and bank investments, but German investors remain divided on
the case for a bull market in these once unloved assets.

The pessimists on Europe have had a hard time lately. Since the start of 2013 equity markets have rallied by nearly 20%, peripheral bond yields have fallen steadily to new lows and bank stocks have outperformed the broad market by a hefty margin.

These trends are based on good fundamentals, reckons Jeffrey Taylor (pictured), head of European Equities and fund manager at Invesco Perpetual: “The imbalances have been reduced substantially. The widely-held views, that the
continent will not manage to grow again or that the euro will break up, have been proven wrong.”

Equity fund managers are not alone in their more rosy assessment of European fortunes, especially those in southern Europe. Investors have added a record $53bn to equity funds dedicated to western Europe in 2013, a recent EPFR study found. At the same time they have divested from the core of Europe, draining Germany-focused funds by $8.6bn.

“American investors have come back to Europe ever since Mario Draghi gave his ‘Whatever it takes’ speech,” says Thomas Zuschlag, who heads the Swiss subsidiary of the German fund-of-funds investor Sauren. Whereas the Cologne-based investment firm concentrates mainly on fund selection and thus prefers to be invested across themes and trends, Zuschlag is responsible for a more focused strategy. He sees that fund managers have recently tilted their portfolios to benefit from “normalisation” in peripheral Europe.

“More aggressive strategies that focused on undervalued and neglected assets have outperformed significantly for the second half of 2013,” says
Thomas Romig, who is in charge of Multi Asset products at Union Investment and oversees more than €7bn in assets. The relative outperformance of more value-oriented strategies in Europe against the “defensive-growth” concepts – that have been in favour among many investors for the past few years – therefore did not come as a surprise to Romig.

“The trend to safer stocks has been a longer term one, the recent underperformance is not proof of a normalisation yet,” he says. Thus the catching-up of Spanish or Italian stock markets and their respective bank equities could still continue, as valuations remain depressed. “The market expects peripheral countries to emerge from their mess,” says Romig. To achieve this, the region might still need support. He believes that private consumption and reform efforts both need to rise this year.

Otherwise, the ECB could support the region further. This could especially help the banking system in the region. “The supportive policies of the ECB were very positive for asset prices and this meant lower write-offs at many
banks, for instance for peripheral bonds.” On these grounds the Asset Quality Review might be no major event for the markets, reckons Romig.
Indeed, investors have switched to a more constructive view on the banking system. “There are a lot of institutions that have rebuilt their capital base and worked on their business model. Thus we have an overweight in financial stocks in our fund, even though we would not buy into the sector indiscriminately,” says fund manager Taylor.

In some market segments he sees a “survivor’s party”, as a massive consolidation wave has reduced competition, for instance in the Spanish banking market. In comparison, however, European banks still lag. The Bank for International Settlements (BIS) did a thorough analysis of the banking systems of industrialised economies recently and found that European institutions still face tougher capital market conditions than their US and UK peers.

For instance, big US banks already trade above book value, whereas discounts in Europe are often higher than 50%. Not all have turned bullish on banks. “Some sectors have fallen behind for good reasons, for instance the banks,” cautions Heinz-Werner Rapp, the chief investment officer of Bad-Homburg-based Investment Group Feri. Even as the European Central Bank has propped up many markets “… the banking sector is in the
midst of restructuring, adding to that litigation risks due to scandals and closer supervision.”

Rapp thus expects that the hope of a short-term recovery might be overdone. He considers a timeframe of three to five years more appropriate when considering an investment in bank stocks. “One still needs to consider the mistrust of regulators and shareholders alike.”

Adding to that, Zuschlag of Sauren sees significant regulatory risks for the sector that have remained unresolved: “Question marks remain for the issue of the Banking Union.” This uncertainty beleaguers the second pillar of the Union, the resolution mechanism. Uncertainties like this might thus hold back the market for banking stocks even though valuations might be cheaper than elsewhere, and discounts deeper than for instance in the US, thinks Rapp.

Indeed, relative valuations to the US might be one of the key arguments for a European market that has rallied for 18 months. On a cyclically-adjusted basis, price/earnings multiples for the European periphery are up to 60% discounted to their historical average, whereas US equities are a bit more expensive than their historic mean. “For an investor it is safer to invest in cheap peripheral stocks than in expensive US ones. The riskiest strategy is to buy overvalued equities,” warns Taylor. Even as he still expects headwinds for Europe, a lot is still priced in, the fund manager thinks.

“Even after the recovery of 2012 and 2013 European equities remain relatively cheap. They offer the best potential in terms of earnings. In Europe it is still possible to find undervalued companies.” Rapp observes the combination of “hoping and healing” in Europe. “Parts of the equity markets in the periphery were unloved and neglected, and a significant catching-up process has already happened in 2013 as the risk of a break-up of the euro or the political turmoil in Italy have been priced out.”

But that means that valuations were already bid up by eager investors. Rapp therefore considers the periphery as a whole to be “much less attractive than in 2012,” even as he finds some markets offer more chances than others. But overall equities could be prone for a correction.
“The market is heading for some overheating,” warns Rapp. Some markets have moved “too quickly too far.”

Right now, it might thus make more sense to hold a broadly diversified portfolio rather than picking a few, aggressive bets on sectors and countries. In 2013 these bets were much more attractively priced. “In 2014
companies need to deliver what many investors have already anticipated last year,” Rapp says.

But the higher P/Es might be justified, given the still low bond yields, suggests Union Investment Multi Asset manager Romig: “The multiple expansion is connected with the low yield environment. The average European bond yield has not risen by much in 2013, this still
supports the equity market.”

Indeed, a look at European bond yields shows that on average, 10-year eurozone government bonds yield only 0.7% more than in May 2013. In the same time, the discussion about tapering has shifted the 10-year US
government bond yield nearly 1.3% higher.

Thus, part of the strong performance of European stocks still depends on foreign fund flows. “US investors came back in 2013 because they appreciated the value gap to US equities,” says Romig. Yet within Europe “not many investors have moved strongly into stocks.” The often-proclaimed ‘Great Rotation’ – a broadly based move out of bond markets and into equities – is foremost a US phenomenon, thinks Romig.

Thus, overall he sees potential in the periphery both “from a macro and a micro point of view.” The economic cycle might have turned in 2013, and many companies could feel more tailwinds in 2014. But the strong gains of 2013 have also created room for countermotion. “A correction is possible, though not likely in the short term,” thinks Romig. In the last year, there
were few political obstacles to equity market outperformance. “It was rather quiet in Europe,” he says.

The mixture of supportive monetary policy, positive fund flows and improving macroeconomic fundamentals could provide a further boost to markets, “but an investor in equity markets always needs to be prepared for a correction.” After one and a half years of significant returns this
might be even more so. Nevertheless, the positive signs prevail – and temporary corrections might turn out to be buying opportunities in the longer term.

One catalyst for further gains could be the ECB. “I still expect the ECB to come out with some bold new measures in 2014,” says Rapp. “They will be aiming at weakening the euro, which would be good news for exporters.” At the same time the central bank could look at further measures to reduce credit spreads for peripheral companies. This could provide further tailwinds for peripheral capital markets.

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