Delphi’s Espen Furnes sees a comeback for European shares

Espen Furnes, manager of the Delphi Europe fund, sees three key factors pointing to a positive period for European equities.

After having a broken back for several years, Europe has once again captured the attention of investors. European consumers are opening their wallets, industrial production is increasing, trade balances are improving and share prices are rising.

The European economy has had a hard time during the past few years. Not only did the financial crisis in 2008 heavily affect Europe, but it was also followed by the eurozone crisis. The latter was due to sharp growth and over-investments, as well as to excessive wage growth compared to productivity in peripheral Europe. All this was enabled by the euro cooperation and its mechanisms. The past few months’ macro figures have shown a clear change of mood in the eurozone. Although we do not envisage a more normal growth rate in the near future, it is important to investors that the macro figures show signs of recovery. This leads to greater predictability and trust and to the economic laws of gravity once again functioning.

A strong European summer

Conditions in the eurozone gradually improved a lot during the summer. At the beginning of the year, investors did not expect the eurozone to get out of the recession until the end of 2013. Now it appears that the recession was in reality already over in July. The shift can be explained as follows: many savings packages and tax increases were implemented in the eurozone in 2011 and 2012. These were having a full effect at the end of 2012. In 2013, it has not been necessary to implement further measures, and this also explains the upturn. Draining consumers’ wallets produces negative economic effects. Consumers spend less money and industry reduces its capacity. Economic activity slows. Once this drainage process is over, the negative forces that are putting downward pressure on the economy disappear. When additional austerity measures are also priced into the share prices and then do not take place, investors realise that attractive investment opportunities exist. The result is the positive developments in European shares that we have seen in the second half of the year.

A further upturn is expected

To put it simply, there are three factors which indicate we are now facing a good period for European shares:

1) The consumers: European consumers have once more started to spend more money. The shift in trade in the eurozone took place at around the beginning of July. This has been especially visible in peripheral Europe, where the greatest consumption cutbacks have taken place. Tax hikes and uncertainty about incomes are usually effective triggers for a thrift culture. In that sense, the fact that consumers are once again opening their wallets is an important signal.

2) The manufacturing industry: leading manufacturing industry indicators are yet again positive, with scores of over 50 (Manufacturing PMI for the eurozone). This indicator is based on the companies’ production expectations for the next three months. A score of above 50 indicates that the majority are planning to increase their production. In 2011 and 2012, this indicator was clearly negative.

3) The balance of trade: the eurozone’s balance of trade is positive for the first time in very many years. Imports have declined and exports have increased. This means that new debt does not have to be raised to finance imports and that the economies are at last making money again.

The fact that the consumers and manufacturing industry have changed for the better at the same time is the key to all this. Although consumption in the eurozone is not yet growing, the trend has turned and improved much more quickly than was expected at the beginning of the year. So far, this has not resulted in less unemployment. That was also not to be expected. While sales are immediate and the manufacturing industry is a leader, unemployment lags behind. The latter usually improves after a period of economic upturn.

So what about the stock market?

The stock markets in the US and Europe are often viewed together. The US has done better than Europe so far this year, especially compared to the eurozone countries. This is perhaps not all that strange since European shares were “banned” at the beginning of the year, driven by austerity measures and challenges in the peripheral countries. However, the difference has been much greater than can normally be expected. In the past, investors have assumed that what happens in the US will also happen in Europe, usually six to nine months later. This time, investors did not dare to discount such a trend into the prices.

If we look at the pricing of European shares versus American ones, we can see that European shares are currently priced at around 1.3x their book value (Euro Stoxx 50), while American shares are correspondingly priced at around 2.3x (S&P 500). American shares are almost always priced higher than European ones. However, the difference is a good deal greater now than normal for such periods.

If we conclude this line of argument by looking at earnings in Europe and the US, we can see that European earnings have fallen during a period when US earnings have risen sharply. Normally, these follow each other quite closely and we have to go back several decades to find a similar gap. Earnings growth in Europe is artificially low. We believe this gap will close in future due to the current improvement in the eurozone. Consumption and the manufacturing industry respectively make up around 55% and 45% of the European economy. Both have been kick-started again, indicating that earnings growth will return. As a result, we believe Europe has a greater potential for structural earnings growth than the US. European shares are cheaper and have not done as well as US shares and European companies’ earnings will probably grow more rapidly during the next two years.

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