Executive summary: Macro: Cautiously optimistic

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Gary Underwood
6 years ago
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1 FOR PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY REVIEW & OUTLOOK Q European Equity Barometer Executive summary: Macro: cautiously optimistic Earnings: best in a decade outlook Valuation: in a low-yield environment, relative valuations are key Nigel Bolton Head of the BlackRock European Equity team Explaining the indicator Positioning: investors are warming up to the European story Macro: Cautiously optimistic The eurozone economy remains buoyant with the June manufacturing Purchasing Manager s Index s (PMI), regarded as a reliable gauge of the economy, pointing to the fastest rate of expansion in six years. Job creation was one of the strongest recorded over the past decade as firms continued to expand capacity in response to rising demand. Q Q As a reminder, there are four factors that we monitor. We have devised a schematic to clearly illustrate the current strength of each factor and how that has changed since last time. The dark blue needle indicates our current view and the light grey needle indicates our last reading. Far right is the strongest, or most positive reading with the middle position neutral and far left the weakest or most negative reading. In the UK, we have seen pressures on the consumer via a weaker currency and the consequent imported inflation. Wages fell behind consumer price inflation (CPI) despite historically low unemployment, as it rose to a four-year high. Britain s growth in the first quarter was confirmed as the slowest of the G7 nations as the slowdown in consumer spending took its toll. However, despite some evidence of the economy losing momentum, given the openness of its economy, the UK has benefitted from the ongoing cyclical upswing in global demand and its economy is now expected to expand by 1.7% in 2017, up from an estimate of 1.2% in January (World Bank). Our stock selection remains selective in the UK as consumer spending power falls which could put pressure on UK businesses. While global expansion continues at a steady pace together with eurozone economic growth progressing well, inflation remains well below target. Investors concern regarding a deflationary spiral in the eurozone have dissipated but subdued inflation expectations remain the most likely outcome as per chart 1. The European Central Bank (ECB) faces constraints on asset purchases as it approaches self-imposed limits. Its plans for winding down purchases could be complicated if core inflation stays low. The latest reading for core inflation in June 2017, which excludes changes in prices for volatile goods such as energy, food, alcohol and tobacco, was +1.1% (Eurostat, July 2017). As the oil price effect annualises out, we also think headline inflation, which is targeted by the ECB may remain under target. blackrock.com Equities team and are subject to change with market conditions. They are not to be

2 Ongoing developments in the Italian and Portuguese banking sectors highlight the scale of bad loans still embedded in the eurozone nine years after the financial crisis. Accordingly, we believe that the ECB is wary of the robustness of the eurozone s recovery and will monitor the region s economic performance as closely as ever for any signs of slippage from current levels. The ECB is acutely aware that any significant Quantative Easing (QE) reversal runs the risk of a misstep that would send yields spiking, hurting risk assets and the eurozone s steady expansion. As such, we see the ECB unwinding cautiously. We expect the ECB to demonstrate patience in such a delicate policy transition which was reiterated in its last speech in July. The optimism the market has around the rate environment moving higher, in our opinion, is likely to fade. In addition, there are some structural arguments against a sharp increase in interest rates: Demographics: in a society with a rising dependency ratio, real yields must stay low to incentivise workers to retire later than previous generations. High level of debt in the US, the eurozone and Japan: all are reliant on low interest rates for debt servicing in critical sectors of their economies. This is an important reason why the Federal Reserve (Fed) is treading cautiously in raising rates and other central banks appear slow to follow the same path. Pricing power pressure in every industry: from consumer goods to oil, telecoms, healthcare etc sector after sector, we see little evidence of an inflationary trend. Overall, despite grinding levels of economic growth, caution is the watchword for central bankers with respect to the economy. As we have seen in the US, an unprecedentedly gradual approach to monetary policy normalisation is expected from the ECB. They remain acutely aware of the ongoing levels of indebtedness that persist and the fragility of sentiment. Chart 1: Five-year inflation expectations, Annual change 3% Japan Eurozone Source: BlackRock Investment Institute, with data from Thomson Reuters, May Note: We take all components in a CPI basket (excluding food and energy) to see which make statistically significant price moves relative to the median on a monthly basis. We then exclude those volatile components to gauge underlying inflationary pressures. Earnings: Best in a decade outlook European earnings are reflecting global improvement, as evidenced by the strong first-quarter reporting season, which has been the best in several years. The momentum we see comes from across the world, and European companies are benefitting from overall better global growth. The first quarter reporting season was indeed extremely strong with earning per share (EPS) growth up 23% year-on-year. In addition, the ratio of upward to downward estimate revisions by analysts has surged to the highest level in over five years. The improved earnings performances this time are being driven by sales increases and operating leverage rather than rationalisation and cost initiatives. This has been a catalyst to European equities performing well on the back of strong earnings, rather than just re-rating as seen in previous years. We believe that there is further upside because we anticipate the second quarter earnings season to remain robust, albeit not as strong as Q1. European economic activity remains strong across all regions as evidenced by the manufacturing PMIs. The pick-up in sales growth has led to a significant recovery in profits. The corporate earnings picture has brightened, feeding into a rebound in capex spending. See chart 2. In the US, corporates have taken full advantage of cheap credit availability and increased leverage to levels exceeding those existing before the 2008 financial crisis. In stark contrast, European US 2 EUROPEAN EQUITY BAROMETER

3 corporates typically have rebuilt their balance sheets and now sit on piles of cash. Despite this relative balance sheet robustness, European corporates have been reluctant to reinvest in their businesses, due to the backdrop of political and economic uncertainty. As such, we see a number of opportunities for companies benefitting from a capex spending recovery in the eurozone. Capacity utilisation (a measure of productive efficiency) in the euro area has been progressively moving higher and we anticipate further capacity additions going forward i.e. higher capex spending. Chart 2: Eurozone non-residential capex as a % of GDP Such a view feeds directly into how we think about valuations in this post-crisis environment. If discount rates for judging asset prices are not poised to revert to their historical average, then perhaps we need to look at valuations through a different lens. Even though eurozone bond yields edged higher at the beginning of July, as markets interpreted ECB remarks as hawkish, European equities remain relatively inexpensive when compared with fixed income and especially in terms of dividend yield. See chart 4. Chart 3: US and European P/E ratios, % 25% US % of GDP Eurozone non-residential fixed investment % of GDP Average Forward P/E ratio Eurozone Source: JP Morgan, July Valuation: In a low-yield environment, relative valuations are key European equities have traded at a valuation discount to US peers. See chart 3. It could be argued that this persistent discount is justified given factors such as the US s large and highly valued technology sector, as well as the relative weakness of the eurozone s banking sector and less globally competitive companies. However, structural reforms, such as greater labour market flexibility, could unlock more of Europe s growth potential and raise return on equity, which could narrow a portion of Europe s valuation discount over time. Crucially, this means that politicians need to deliver. We believe that structurally lower growth and lower interest rates suggest that comparing valuation metrics from the past may not be such a reliable guide to the future. We expect rates to gradually rise but stay low and well below the historical average. Source: BlackRock Investment Institute, with data from MSCI and Thomson Reuters, July Note: The lines show the 12-month forward P/E ratio for the MSCI US and Europe indexes. Positioning: Investors are warming up to the European story Years of investor pessimism on Europe seem to be shifting towards cautious optimism. Europe s economy is enjoying a cyclical upswing, supported by a still accommodative ECB. In addition, the two largest countries and longtime drivers of integration, Germany and France, are poised to have pro-european, newly legitimised governments. Emmanuel Macron s party has won a large majority in parliament, giving the French president leeway to pass labour and tax reforms needed to revive growth. Polls suggest German Chancellor Angela Merkel is likely to win a fourth term in September, with an eye to preserving her legacy as a defender of European integration. Fears of populism spreading to Europe from the US and UK appear to have subsided for the time being. EUROPEAN EQUITY BAROMETER 3

4 With near-term political risks fading and earnings improving, investors started to come back to the asset class following a protracted period of outflows, a trend we expect to continue. Chart 4: Equity, sovereign and credit yields Yield 9% iboxx Euro Corp bond yield MSCI EMU: Dividend yield Bund 10yr yield Source: Barclays, July Summary As with driving, you are most alert immediately after a near accident. Similarly, with the eurozone, after the near accident in the Dutch and French elections, and the disarray caused by Brexit, the eurozone leaders may believe this is an unprecedented opportunity to implement reforms that make the EU s success more assured. The chances of this have increased incrementally given Macron s clear election win (and Merkel s probable win) as this provides political and economic cohesion for the two key pillars of the European Union. While it is difficult to separate the economic benefits of the wider global expansion on the eurozone, compared to the improving fundamentals of the eurozone itself, we believe that the background of an accommodative ECB, subdued inflation, the recent decline in political risk and the chance of beneficial reform, collectively, have underpinned the attraction of European equities. The strength of Q eurozone earnings, driven by rising sales, is particularly encouraging. Against a background of valuations that we believe remain undemanding, we retain our confidence that investors will continue to increase weightings to this asset class. 4 EUROPEAN EQUITY BAROMETER

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