14 March, 2018 John Authers
Here we go again. I am going to suggest that it might be time to buy European equities. And in particular, it might even be time to buy equities from the UK (which is still politically part of the EU).
I have made this argument on a number of occasions in the past, and it has not always worked well. European equities have looked cheap relative to US equities for years now, but there has been good reason for that. But last year you would, contrary to many perceptions, have made more money in European stock markets than in the US. And the moves of the past few weeks have again made Europe look attractive.
To start, here is the gap between the price-to-book multiples on US and European stocks, and how they have changed over time:
There are reasons why the US stock market is more expensive than its European counterpart, but they can mostly be condensed into one syllable: tech. The US has Silicon Valley and the Fang stocks, and Europe does not. Many large US tech stocks are still going through a period of secular growth, so it is natural that the US as a whole should sell at a premium. But why has the premium widened significantly since Europe began to emerge from the eurozone sovereign debt crisis five years ago?
Also, it is noticeable that European equity performance has ground to a halt. While the US has enjoyed the Trump bull market (fuelled in large part by the weak dollar), European equities have suffered from the strong euro, and have been hit harder by the recent volatility:
This is strange because ISM supply manager surveys remain far more positive for Europe than they do for the US. Most tellingly, there is the difference in monetary policy. The US is (very slowly) withdrawing from crisis-era monetary policy. The eurozone, through the European Central Bank, is still buying up assets. As a result the gap between US and German bond yields has widened to a post-eurozone crisis high:
Rising bond yields are widely and probably correctly cited as the key catalyst for the correction in the US. Why then has the correction hit harder in Europe, where stock valuations should benefit from cheap money from the central bank for a while longer?
Politics is one obvious answer. Europe has staged a series of elections that markets found frightening since the US last held a presidential election. But none of the outcomes has been particularly scary. Investors got exactly what they wanted in the Netherlands and (particularly) in France, and Angela Merkel survived in power in Germany. This month’s election in Italy made nobody outside Italy very happy, but it did not come as a great surprise — and in any case, Italian assets have been performing better than most of the rest of the continent. And on top of that, it is not as though the US does not have to deal with some political uncertainty of its own.
All of this suggests that even Europe has been a popular investment for a while, on the grounds of valuation, it might still be an interesting investment. And interest in Europe does appear to be falling a little. European equity allocation is the lowest in almost a year, according to the last BofAML survey of fund managers. The summary of the survey’s findings is as follows:
Global investors’ allocation to European equities dropped to net 41% OW from net 45% last month, the lowest since March ’17. Meanwhile, UK equities have been underweighted for 47 consecutive months. Intentions to own Europe are waning, but this seems more of a "relative" call. Despite improving confidence in European earnings, the US and EM profit cycles are seen as increasingly favourable compared to the European cycle
BofAML suggests that this is largely because hopes for profits in the US (aided by the tax cut) and in Japan have now largely caught up with Europe.
It remains clear that those investing in Europe are still doing so in the hopes of strong earnings growth, with many of them expecting growth in double-digits.
Direct questions of fund managers similarly confirmed that profits growth, plus some signs that the eurozone has sorted itself out and made some important structural reforms, remain the things that investors most want to see. Neither of these is anything like certain, and the prospects for eurozone reform have almost certainly weakened following the results of the Italian election (although they look far, far better than they would have done had Marine Le Pen triumphed in France).
This does lead to one last area of concern, which is that investors do remain overweight in Europe, even if they are steadily moving away from that position.
That leads to the contrarian opportunity of the moment. If you really want to invest in a country that is seriously out of favour, and has been for a long time, try the UK. This is the same exercise carried out for the UK:
Global fund managers have been net underweight in the UK for almost four years now, and dislike for the UK remains almost universal. It is difficult to see how revulsion can proceed much further from here.
Without wanting to revive some of the infuriating arguments about the verdict of the stock market that came up in the first few days after the Brexit referendum, it bears pointing out that as far as the market is concerned the UK stands to lose out terribly compared to the rest of Europe as a result of leaving the EU. As the chart shows, this is true whether you use the FTSE 100 large-cap index, or the smaller companies in the FTSE 250 index.
The chart is in common currency terms and shows a dramatic loss of confidence in the UK, particularly given that this period included lengthy stretches of angst when investors were worried about political risks in France, the Netherlands, Germany and Italy.
Uniform performance from both the FTSE 100 and FTSE 250 is unusual. To demonstrate this, look at the performance of the FTSE 250 compared to the rest of Europe, since the establishment of the euro:
And now compare it with the dreadful performance of the multinationals in the FTSE 100:
The latest nadir comes from the latest economic bulletin from the Chancellor of the UK. As Fiona Cincotta of City Index pointed out:
There was actually little to cheer despite the upbeat presentation from an unusually positive [Philip] Hammond. Whilst an upward revision for 2018 is certainly something to be excited about, let’s not lose track of the fact that this is the first time in modern history that GDP growth is forecast to be below 2% for each year forecast (until 2022). A woeful outlook by historical standards. And this is still subject to Brexit related uncertainties. Regardless of how positive Hammond’s performance, there is no escaping that at a time when the rest of the world is booming, the UK is staring an extended period of weak growth in the face.
Then of course the UK’s attempt to fashion a viable post-Brexit settlement appears to be going terribly, amping up the uncertainty. But it is quite possible that enough bad news is now in the price.
I am a Financial Times columnist, I completely agree with the FT’s editorial line on Brexit, and I voted Remain myself. I would certainly do so again given the chance. But I do wonder whether the negative economic consequences of Brexit for the UK have been exaggerated. One helpful commenter drew my attention to this working paper published by the University of Cambridge entitled "How the Economics Profession Got It Wrong On Brexit". Some early words from the introduction suffice to give a flavour:
Our conclusion is that most estimates of the impact of Brexit in the UK, both short-term and long-term, have exaggerated the degree of potential damage to the UK economy. We stress at this point that this is not a politically-driven exercise. Most of the four-person team behind the research for this and our other papers voted ’Remain’ in the 2016 referendum and would do so again if given the chance. Our purpose is rather to establish a sound basis for the ongoing debate on the likely potential economic impact of Brexit, and more generally to question the quality of economic analysis in dealing with major, macroeconomic policy issue like Brexit.
Many fundamental questions for the future of the UK arise from the Brexit mess, and from the issues in this paper. One of the least important, but most interesting if you are an international investor, is the strong implication that the UK might well by now be a contrarian buying opportunity.
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