Stockpickers will benefit from continued good performances from the best European companies next year - even those located in the periphery - says Schroders' head of European Equities Rory Bateman.
Stockpickers will benefit from continued good performances from the best European companies next year – even those located in the periphery – says Schroders’ head of European Equities Rory Bateman.
Europe houses some of the best companies in the world; market-leading franchises, all too eager to take advantage of demand growth across global markets. For us, there is a wealth of neglected European ‘stars’, which are offering increasingly good value as fearful investors wait in the wings until the dust settles.
European equities: catalysts for change The Draghi ‘put’
The level and degree of changes that we have seen through central bank monetary policy since Mario Draghi’s arrival have been significant. The policy shift has been viewed by many commentators as a ‘game-changer’ for Europe. In our view, the measures taken are substantial and, at the very least, reduce the tail risk of a eurozone breakup. Importantly, we are starting to see more political and economic cohesion between the authorities and, ultimately, this cooperation will be a pre-requisite for the survival of the eurozone project.
Eurozone debt in perspective
The concept of European Central Bank (ECB) quantitative easing was not considered two years ago, with Jean-Claude Trichet at the helm. However, Mario Draghi has been a different story. He has been much more proactive – pledging to do ‘whatever it takes’ to save the euro; bringing down interest rates, rolling out three-year Long Term Refinancing Operations (LTROs) to support the banking sector and, more recently, introducing the possibility of open-ended, unlimited bond buying – coined Outright Monetary Transactions (OMT). The measures have been taken to redress the impaired monetary transmission mechanism in Europe and help stabilise the single currency.
They have effectively lowered the cost of borrowing for Spain and Italy, while staving off contagion risk to date. If we take the view that any potential fallout from Greece is contained and the eurozone will still be around in five years’ time, then it makes sense to look at the euro region as one entity. Laying Greece to one side, if you aggregate all the government and household debt within the eurozone economies, the gross debt as a percentage of GDP looks to be in decent shape relative to the US and Japan.
Ultimately, if the political will exists and we move towards a ‘federal solution’ for the eurozone, when the member countries emerge on the other side they may very well be in a better state from a debt perspective than the other major trading areas.
The equity market performance gap: Europe versus US The differential between the performance of European and US equities sits at a historical high; currently over 28%. While the chart reveals nothing about valuation, it perhaps suggests that now may not be a bad time to think about allocating funds to European equities.What can we expect in 2013 and beyond?
European re-rating opportunity
While central bank actions have helped to reduce the sovereign tail risk in Europe,
investors are still fearful and the equity risk premium (ERP) in Europe remains close to all time highs. While these recent concerns have abated, it remains historically high.
The ERP is a function of the bond yields, which are clearly artificially low. However, even with an ERP at c. 9.5% and higher bond yields (let’s say normalised at 2%), it is still very high, almost double the historic average in Europe. This compares with an ERP in the US of c. 6%. (Source: Schroders, Thomson DataStream) Given this, we question whether fixed income investors are being compensated for the risk they are taking.
Many areas of the fixed income market look to be in bubble territory while expectations for European equities are already very low. For example, 2013 earnings forecasts in Europe are some 40% below the 2007 peak whereas in the US, earnings expectations are 10% ahead of the 2007 peak.
As the tail risks of a eurozone break up begin to recede, we should start to see the ERP come down offering a significant re-rating opportunity through 2013 and beyond.