Lazard Insights Europe: The Recovery No One Wants to Talk About John Reinsberg, Deputy Chairman Summary After an era of slow growth combined with a rather tepid and depressed outlook, we now believe that Europe and European companies may be entering a sustainable period of recovery. European economic and sentiment indicators are clearly improving alongside European GDP and investors have responded to these improvements, with European equities now approaching their 214 highs, although they are still significantly below their 27 peak. Economic improvements have translated into stronger results among European companies, with earnings upgrades once again consistently outnumbering downgrades. Relative to other global opportunities, we believe that European equities pose an attractive return opportunity for investors. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author. The original recording can be accessed via www.lazardnet.com/insights. What a difference a year makes. After an era of slow growth combined with a rather tepid and depressed outlook, Europe and European companies may be entering a sustainable period of recovery. The nature of this recovery is different compared to previous short-lived global recoveries. First, the global economy appears to be in much better shape, with more of a synchronized global expansion as evidenced by new OECD data.¹ European purchasing managers indices are also sharply higher from their financial crisis lows (Exhibit 1). Second, Europe is the last of the world s major regional blocs to recover after a period of persistent and significant uncertainty. This is unlike the past, when Europe often led the short-lived global recoveries. Exhibit 1 Synchronized Global Recovery Purchasing Managers Indices 58 Expansion 54 5 46 214 Contraction 215 As of 31 March 217 Source: Bloomberg, Caixin, Markit, Nikkei 216 Euro Zone UK US Japan China 217
2 With this backdrop, the signals are pointing to an improved macro and micro outlook for European companies. Relative to other global opportunities, European equities pose an attractive return opportunity for investors. The Facts European economic and sentiment indicators are clearly improving: Economic leading indicators are strong Business, manufacturing, and consumer sentiment are above average First quarter GDP growth exceeded expectations Unemployment is improving The euro has stabilized against the US dollar German industrial production is strong and Germany s IFO Business Climate Index is at a record high (Exhibit 2). Germany currently contributes about 35% to the euro zone s GDP and the IFO index is generally regarded as a key leading indicator for the region s growth (albeit it can overstate the direction). The latest IFO reading in May suggests 3% growth for the euro zone. While the consensus expectation is 1.7%, we believe that 2% or more may be a strong possibility. More broadly, economic sentiment in Europe has been above average since 214 and has strengthened since then. European manufacturing and retail sales surveys show a similar positive pattern. In fact, retail sales sentiment is at its strongest since the financial crisis began in 28 (Exhibit 3). First-quarter European GDP growth modestly beat expectations and was positive across all nineteen countries of the euro zone. Most encouraging, the sources of this economic activity have broadened to include capital investment as a key driver alongside consumption (Exhibit 4). European unemployment remains high but is improving, showing that there is room for an extended recovery in countries such as Spain. The jobless rate in Spain declined from a record 26.3% in 213 to 18.1% in March 217. Greek unemployment has recently fallen to the lowest level since 212, from 27.9% in 213 to 22.5% in March (Exhibit 5). Reflecting some of these economic improvements, the euro has stabilized against the dollar. Exhibit 2 German Business Sentiment Suggests Stronger Growth Ahead for Europe Index 6 12 3-3 -6 GDP Growth [LHS] IFO Index [RHS] 1997 21 25 As of 7 June 217 Source: Thomson Reuters Datastream 29 213 217 Exhibit 3 European Economic Survey Indicators Are Now Above Average 1-1 Industrial Production [LHS] Retail Sales [LHS] Overall Sentiment [RHS] -2 21 23 25 27 29 211 213 215 11 1 9 8 Index 12 1 8 6 217 Through 31 March 217 Overall sentiment values over 1 indicate above-average economic sentiment whereas values below 1 indicate below-average sentiment. Industrial production and retail sales indicators are calculated by subtracting the percentage of negative responses from that of favorable responses. Source: European Commission Exhibit 4 Sustainable Sources of European Growth 1.5. -1.5-3. Private Consumption Government Gross Fixed Capital Formation Changes in Inventories Net Exports Real GDP Growth 27 29 211 213 215 217 Through 31 March 217 Represents GDP growth for the European Union. Source: Statistical Office of the European Committees
3 The Market Response Investors have begun to notice these improvements: European equities are near their 214 highs Year to date, European equities have outperformed US and Japanese stocks US-domiciled European equity fund inflows have set a record Euro zone investor sentiment just hit a 1-year high. At the same time, European equities are approaching their 214 highs, but are still significantly below their 27 peak (Exhibit 6). For US dollar based investors, the MSCI Europe Index is up 13.4% for the year through 23 June. By comparison, the MSCI USA is up 9.1%, the MSCI Japan Index is up 9.9%, and the MSCI Emerging Markets Index advanced 17.3% over the same period of time. US-domiciled European equity fund flows surged in March and weekly inflows gathered momentum in May, crossing a record high of $6 billion.² As of the end of May, US-listed European equity ETFs recovered slightly more than 4% of their 216 outflows, at $13.2 billion (Exhibit 7). We expect European conditions to continue to improve, noting however that differences still exist between countries. There are several key drivers of the recovery: European monetary policy is expected to remain supportive Labor productivity has been improving European capital investment has strongly rebounded from a trough in 213 Populism appears contained for now European monetary policy is expected to remain supportive in a backdrop of contained inflation risk, given low energy prices. With that said, we expect that a tapering exercise may begin in the short term, and actual tightening may begin in 218 at a measured pace. Meanwhile, labor productivity has been improving in France and Germany since 28, although it has stagnated in Italy. European capital investment has strongly rebounded from a trough in 213, accompanied by a resumption of GDP growth. Gross capital formation accelerated sharply in 217, which given its historical positive correlation to GDP growth suggests continued strong signals for Europe. In terms of political uncertainty, the rise of populism in Europe appears to be more muted, at least for now. Centrist victories in France and the Netherlands provide some needed reassurance around the stability of a fragile European Union. Notably, a new European political elite is being formed, often with almost no ties to pre-existing parties. Exhibit 5 European Unemployment Is Improving 3 2 1 1999 21 23 25 27 29 Through 31 May 217 Source: Statistical Office of the European Communities 211 Exhibit 6 European Equities Are Still Below Their Peak Index, 1=1 January 1986 9 7 5 3 1 1989 1993 Through 31 May 217 Source: MSCI MSCI Europe 1997 21 25 213 29 Exhibit 7 European Equity Fund Inflows Accelerated in 217 ($ Billions) 12 6-6 -12 Jan 29 ETF Mutual Fund Sep 21 As of 31 May 217 Based on monthly flows. Source: Morningstar May 212 Jan 214 Sep 215 215 Greece Spain Italy Euro Area 19 213 217 217 May 217
4 Exhibit 8 Construction Activity is Picking Up Residential Building Permits 3 3 Non-Residential Building Permits 2 24 2 15 12 1 1-3 5-12 22 24 26 28 21 212 214-6 216 22 24 26 28 21 212 214-24 216 12-month average sq/m, 1=21 [LHS] Y/Y Change [RHS] As of 31 December 216 Based on the EU 19. Source: Eurostat, FactSet The Company View Economic improvements have translated into stronger results among European companies: Earnings upgrades are once again consistently outnumbering downgrades In the past twelve months alone, earnings expectations for European companies in the MSCI Europe Index have risen from 13.9% to 23.2%. From a bottom-up basis, our European company and sector perspectives are generally positive: Construction and industrial companies could benefit from demand tailwinds Automotive companies are seeing rising sales Banks could be entering a more supportive financial environment Transportation companies are seeing more activity European housing and non-residential permits are bouncing off the bottom, with demand outpacing supply (Exhibit 8). We are also seeing pricing improvements in property markets in several European cities as a result of higher cost inflation and Britain s decision to leave the European Union. Credit availability and lending conditions are also improving, which is supportive for construction and industrial companies. For the most part, European consumer confidence has continued its recovery from the 213 lows. The European auto sector is reviving with a marked improvement in new car sales across the board, especially among mass-market models (Exhibit 9). Among European banks, earnings have been pressured in a low rate environment. However, we believe the outlook is improving given the trough in interest rates. Loan growth is also expanding in a Exhibit 9 Europe s Auto Sector Is Reviving Auto Sales (Millions) 2.6 2.2 1.8 1.4 1..6 26 28 21 212 214 216 Spain Italy France SAAR 4MA SAAR 12MA As of 31 December 216 SAAR Seasonally adjusted annual rate; MA moving average Source: Bank of America Merrill Lynch
5 backdrop of economic improvement (Exhibit 1) and, in a cyclical recovery, there could be a prolonged period of relatively low loan losses. As rates normalize, this could create an opportunity for banks to increase their net interest margins. We also observe a positive trend in airfreight, traditionally a proxy for trade and industrial growth. Exhibit 1 Private Sector Credit Growth Is Improving Euro Area 3. 1.5. -1.5-3. Annual Loan Growth [LHS] 21 211 212 Through 31 March 217 Source: European Central Bank Quarterly Change in Stock [RHS] 213 214 215 216 ( Millions) 13, 65, -65, -13, 217 Risks: What Could Derail This European Recovery? We see a number of risks that could potentially upset the progress of Europe s recovery: Geopolitics Extremist activities Halt to global expansion Disorderly Brexit Complacency The European election calendar remains crowded. While key elections in France, the Netherlands, and the United Kingdom have concluded, important elections remain in Germany, Norway, Italy, and Austria (Exhibit 11). In addition, potential referendums in Catalonia and Scotland need to be monitored. Additional terrorist incidents in Europe prior to the Italian and German elections could also create an advantage for fringe parties. So while political risk in Europe has moderated, some issues still remain. Slower economic activity in the United States and China may also affect the European marketplace, especially export-oriented Exhibit 11 Though Still Present, Political Risk Has Abated Euro Area March 217: Netherlands general election May 217: German state election Schwelswig Holstein March 217: UK intends to trigger Article 5 January 217: Socialist primaries in France April 217: French presidential election June 217: French parliamentary elections 1 September 218: Catalonia plans independence referendum May 217: German state election Nordrhein-Westfalen June 217: German state election Saarland October 217: Latest date for German general election October 217: Austrian parliamentary snap election December 216: Italian constitutional referendum May 218: Latest date for Italian general election For illustrative purposes only. Source: Lazard
6 European companies. Along with that, a disorderly Brexit could dampen European sentiment. One more issue to be reckoned with is the potential for European economic conditions to improve too quickly, as this could spur complacency and a slowdown in needed structural reforms, including a European banking union, capital markets union, and fiscal integration. A Significant Valuation Opportunity Europe s improved outlook has helped increase company profits Opportunities for upgrades remain European valuations are attractive relative to some major markets European dividend yields are higher compared to other parts of the world Overall, the data we are receiving from European companies is far more positive than it has been in recent years. This reflects an improved outlook which is translating to the bottom line. The difference between today and the recent past is that there is now a chance that a European improvement actually comes through, putting the season of disappointing earnings behind us. To the extent that European valuations have not yet caught up with earnings expectations, opportunities for upgrades remain. In a world where valuations have risen almost uniformly, Europe continues to present good value (Exhibit 12). European valuations are in line with historical levels, yet they trade at a discount to US stocks and a premium to emerging markets stocks. It should be noted that the European dividend yield of 3% is well above that of many other geographic regions. However, it must be acknowledged that progress is still uneven between countries, sectors, and companies, thus investors would be well served to tread carefully in selecting their positions. Exhibit 12 European Valuations Have Room to Expand MSCI Regions Conclusion Forward P/E a Forward ROE a Dividend Yield ACWI 16.8 12.6 2.4 United States 19. 15.3 2. Continental Europe 16. 11.4 3. Asia ex-japan 16. 9.9 3.7 EAFE 15.5 1.6 3. United Kingdom 15.2 11.9 3.8 Japan 14.7 8.7 2.1 Emerging Markets 12.9 12.1 2.5 As of 31 May 217 a Forward P/E is defined as Price/Earnings FY1 and Forward ROE as Return on Equity NTM. The figures above represent expected returns. Expected returns do not represent a promise or guarantee of future results and are subject to change. Source: MSCI Europe as a whole may just be in its best shape since 28, as it follows in the footsteps of the US economic recovery. We believe that Europe is only just beginning to hit its stride. Assuming that this pattern persists, it should manifest itself more firmly into the investors mindset and the prospects for more dynamic expectations should improve even further. The European recovery that no one wants to talk about offers compelling opportunities for global investors.
7 This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management. Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a robust exchange of ideas throughout the firm. Notes 1 Organization for Economic Co-operation and Development 2 European Stock Funds Gather Momentum as Inflows Cross All-Time Record High of $6 Billion, 12 May 217, http://www.cnbc.com/217/5/12/european-stocks-epfr-deutsche-baml-- macron-france-trump.html Important Information Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in these countries. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their prices more volatile, and their liquidity less than that of large-capitalization or more established companies securities. Published on 22 August 217. This document reflects the views of Lazard Asset Management LLC or its affiliates ( Lazard ) based upon information believed to be reliable as of 3 March 217. There is no guarantee that any forecast or opinion will be realized. This document is provided by Lazard Asset Management LLC or its affiliates ( Lazard ) for informational purposes only. Nothing herein constitutes investment advice or a recommendation relating to any security, commodity, derivative, investment management service or investment product. Investments in securities, derivatives and commodities involve risk, will fluctuate in price, and may result in losses. Certain assets held in Lazard s investment portfolios, in particular alternative investment portfolios, can involve high degrees of risk and volatility when compared to other assets. Similarly, certain assets held in Lazard s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance. Past performance does not guarantee future results. The views expressed herein are subject to change, and may differ from the views of other Lazard investment professionals. This document is intended only for persons residing in jurisdictions where its distribution or availability is consistent with local laws and Lazard s local regulatory authorizations. Please visit www.lazardassetmanagement.com/globaldisclosure for the specific Lazard entities that have issued this document and the scope of their authorized activities. RD199