In the last year, European equities have seen something of a renaissance as the macroeconomic uncertainty that had previously blighted the region faded from view and the majority of Europe’s economies experienced sustained, strengthening growth for the first time since the financial crisis. As the rising tide shows few signs of waning, particularly on a relative basis, we explore the macroeconomic factors driving this trend.
Euro: This has been the financial commentators’ subject of choice over the summer. The euro has rallied 12% against the dollar in 2017. Concerns are being voiced that this may impact the earnings recovery story. We remain relatively sanguine on this; it will affect the multi-national mega-caps but much less so the more domestically focussed small-cap names. Further, the relative interest rate outlook would suggest a strengthening dollar going forward. Ultimately, we believe that the European business cycle will be more important for the direction of markets than currency moves.
Europe’s risk premium: One reason for the strength of the euro that has been mooted is that the euro is now a safe-haven currency. However, this has certainly not been reflected in the equity risk premium. On the political front, Emmanuel Macron’s surge in popularity has faded as he has resorted to old-fashioned politics, such as the nationalistic trend of blocking Italian companies buying French ones. As Angela Merkel has been re-elected, people will start again to focus on a new era of stability in Europe. Merkel’s victory should drive both the equity risk premium down and push markets higher.
Reflation: The boost to markets following Donald Trump’s election and the anticipated impending spending bonanza now seems to be a distant memory. In Europe, inflation is running at 1.8%. The behaviour of certain sectors, especially commodities, over the last few months suggests that the return of inflation could become a significant theme going forward. This would be good news for value stocks and for European equities more generally relative to the World Index as Europe is more of a value-oriented market.
Economic data: Most data points continue to show a very powerful recovery in the domestic European economy. Whilst the second derivative of the growth in leading indicators may be slowing slightly, the key metrics look very positive. The most recent PMI data for Europe as whole came in at 57.4 vs 56.6 in July: it was interesting to note that Italian and Greek readings were at six- and nine-year highs.
Corporate earnings: The euro may impact the large-cap stocks but the small-cap sector continues to flourish. The top-line growth across all countries and most sectors is compounded by the huge operating leverage in corporate Europe. Small-cap earnings in Europe should grow 19% in 2017 and 18% in 2018 – this compares favourably against large-cap estimates of 13% and 10%. This expected outperformance is even more telling when compared with US companies.
Jamie Carter is fund manager at S. W. Mitchell Capital Small-Cap European Fund