In recent years, European equities have lagged other developed markets. While US companies have roared stateside, European stocks have failed to catch fire. A combination of uninspiring numbers and macro gloom has weighed heavily on sentiment. But as the US market moves deeper into late cycle territory, selective low valuations and attractive yields are making Europe increasingly attractive.
There has been a dual headwind for fund flows into the continent. Global active investors have been typically underweight Europe and ETF flows have been subdued. While superficially the European market looks well priced, a more forensic analysis tells a different story.
While bond proxy consumer titans, such as Unilever, have seen big gains in recent years, cyclicals have not enjoyed the tailwind of unprecedented quantitative easing. More interestingly, the flattening of the yield curve, which usually portends a coming recession appears to have had a negligible positive impact on defensive cyclicals.
As large global funds have gobbled up quality growth names, momentum investing has become more and pronounced. This is fuelled the historic chasm between growth and value. In this new paradigm, sectorial differences have taken a back seat to growth or value attributes.
Flight to quality
One can see the justification for the flight to quality growth. Long bond yields are deeply suppressed, and thus reliable dividend yields backed by free cashflow from companies like Henkel and Unilever are attractive. However, cycles don't die of old age and valuations will reach a tipping point. Indeed, September's rotation signalled we are now beginning to see that any pick-up in yield is going to see a strong pivot back towards value.
The relative disparity between growth and value is allowing investors to uncover a rich seam of alpha, particularly in the unloved area of cyclical defensives.
We don't have a crystal ball to foresee when the macro gloom will lift and create a sustained uptick in bond yields. But certainly, an alleviation of the Trump trade wars and conclusion to the Brexit saga could see another more pronounced style rotation and move back into value.
Time to get fiscal
Monetary policy is exhausted in Europe and its central bankers must now act to keep the European project alive. QE is still useful in supporting equity markets, but there seems to be no reason to cut rates. This has been shown to have little effect on capital spending and the real economy. An era of ever lower rates is bad for savers and pension schemes and will fail to spur a more vibrant European economic outlook. It's time for government to take on the stimulus mantle and engage fiscal spending to boost real economic growth.
From a macro perspective, disappointing figures from Europe's powerhouse is worrying, but a weak Germany can be a positive for the whole region, as it will be easier to arrive at a consensus for fiscal spending. The next leg of stimulus could see an expansive push to boost connectivity with Asia, as a riposte to China's Belt and Road initiative.
We also believe the prevailing gloom over Europe's future may be overdone. Recent employment figures were positive. Meanwhile, French GDP beat economists' consensus forecast in the third quarter, up 0.3% on a year-on-year basis, contrasting with Germany, where growth has stagnated as the global trade war rumbles on.
Against this backdrop, on nearly all metrics, value looks astonishingly cheap. Price book ratios has become even more pronounced in recent months - defensive cyclicals can be picked up with PE of around 10 and dividend yields north of five percent.
We have been picking up stocks or adding to positions in sustainable business models that we believe have been indiscriminately de-rated due to style bias. These include: Imerys, the French industrial specialist; DS Smith the innovative packaging company; and, Saint Gobain, a building materials company. We have also been building selective positions in the banking sector, where stocks are trading at huge discounts, as low yields have driven down profitability and negativity prevails over value stocks.
I think only with hindsight of history will this period be viewed as golden opportunity to access European value. For investors, adviser and discretionary fund managers, the opportunity offers a compelling investment case to re-consider the European exposure in their global equity allocation.
Chris Hiorns is manager of the Amity European fund at EdenTree Investment Management