A positive outlook for Europe

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Stephanie Butcher, European equities fund manager at Invesco Perpetual, looks at whether there is a case for investing in European equities.

Record low interest rates and tightening credit spreads are pushing investors to look beyond conventional choices in the hunt for income. With talk of the end of the 25-year bull market run in fixed income, many are turning towards the stock market to satisfy their increasing appetite for income.

Equity prices rise and fall with demand; by carefully choosing companies in which to invest, equity income strategies aim to deliver capital appreciation as well as rising income over the longer term. Investment strategies centered on equity income seek to invest in companies with the potential to pay and grow their dividends, and deliver sound returns, aiming to give investors access to income and capital growth potential, whilst providing a more effective hedge against inflation compared to other asset classes.

Why Europe?

I believe there is a case for equity income investing within Europe. European equities are among the highest yielding in the world, just behind the UK, despite the present low growth regime in the eurozone.

In fact, European companies have managed costs tightly through the downturn, and many have wisely accumulated cash during the crisis rather than distributing it. As the challenging Eurozone landscape gradually resolves and economic conditions improve, companies are expected to become stronger and more profitable, allowing cash to be put back to work or returned to shareholders via increased buy-backs and payout ratios. We believe this can translate into higher dividend yields and can play in favour of European equity income investment strategies in the coming period.

Equity yields versus sovereign bond yields are also favourable in Europe, with the spread between equity dividend yields and respective 10-year government yields (the benchmark) higher in comparison with other regions, as figure 1 shows.

We expect this to remain the case in the medium term, with eurozone policymakers determined to keep rates at historical lows, while the US and UK exit their quantitative easing programmes. I believe from a yield perspective, the higher spread makes the eurozone potentially more appealing than other regions.

In addition to higher dividend yields, equity valuations in Europe are also encouraging in my view, with the potential for capital appreciation.

I believe European equities remain attractively valued relative both to developed peers and in historical terms on a price-to-earnings basis. Currently European equities appear to be under-priced, especially for countries and sectors most affected by the euro-crisis, such as Spain, Italy and Ireland, in the periphery and the financial sector, offering the potential for attractive upside in the medium to long term.

Despite geo-political tensions and weak GDP data in Q2, which weighed on economic sentiment and stock markets in recent months, I believe the outlook for Europe remains positive. Domestic demand is finally starting to pick up from very depressed levels while remaining a long way below pre-crisis heights. The periphery is becoming less of a drag on European activity: of particular note is the recovery in Spain, which grew at its fastest rate for six years in Q1 and Q2 this year.

The process of bank de-leveraging, which placed significant burden on lending activity, is now in its final stages, and central bank monetary policies continue to be supportive with further easing announced during the September 2014 governing council meeting. Growth outside of Europe is also set to strengthen after a weak first half of 2014, providing some support for European exporters especially as the strong euro currency has now started to weaken against the dollar. In my view, all these factors ought to accelerate recovery in Europe and allow for interesting growth potential in the coming period.

With the structural headwinds facing Europe in last few years starting to fade, I believe the prospects for equity income in the months and years ahead are bright.

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