16th February 2016
Investors need to step back and consider the bigger picture when it comes to investing in European equities, asserts Vincent Juvyns and Alex Dryden, global market strategists at JP Morgan Asset Management.
Below they outline seven positive forces at play that may bolster European equities and explain why investors should consider retaining or introducing exposure to regional risk assets…
While some European sectors and companies will be negatively affected by the weakness in global trade, slowdown in China and other emerging markets, on balance, we believe that the domestic drivers for Eurozone growth can offset these negatives and help the Eurozone avoid recession.
1. Domestic demand is picking up and will get an extra boost from cheaper oil
We still believe there is plenty of spare capacity in the Eurozone to drive consumption higher. The unemployment rate is falling, but still in double digits, showing that there is plenty of room for improvements. Initial declines in unemployment were driven by the public sector, but we are now seeing more jobs being added in the private sector, a strong sign of a region on the mend. The recent further decline in the oil price will be another boost for consumers and businesses in a region that is heavily dependent on imported energy.
2. The ECB is doing more
The ECB’s December announcement of an extension of its quantitative easing programme to March 2017, as well as a reduction in the deposit rate to -0.3%, might have underwhelmed financial markets, but the changes will see the central bank’s balance sheet expand by a further 33% by March 2017. The ECB looks set to maintain an exceptionally supportive monetary stance for at least another two years which should help keep financing costs low, helping boost credit demand as well as keeping a lid on the value of the euro, which will be supportive for exports.
3. Fiscal policy is getting looser
Fiscal tightening has weighed on Eurozone growth over the last five years. But austerity started to give way to more neutral policy in many countries in 2015 and this trend should continue into 2016, delivering a modest amount of fiscal easing across Europe as a whole. The modest improvement in the fiscal position appears to have taken some pressure off policymakers and encouraged a significant increase in Eurozone government spending in the past year. This is likely to continue in 2016, as countries absorb the additional costs associated with the migration crisis.
4. Investment still lacking but public infrastructure spending set to rise
Investment has been missing from the recovery so far. In contrast to the US, investment fell sharply after the Eurozone crisis and has yet to recover. There is mixed evidence for a turnaround in private investment in 2016, but business investment has picked up in peripheral economies such as Spain. Structural obstacles, coupled with limited growth in private investment and a weakening global environment, explain why we do not expect a significant acceleration in economic growth in the Eurozone in 2016. The combined support of monetary and fiscal policy and the further boost to consumers from the latest decline in the oil price should lift the recovery going in 2016.
5. Non-energy earnings continue to grow
The weaker euro and the domestic recovery are now supporting decent earnings growth in the Eurozone. In fact, the region has experienced the fastest rate of earnings growth of all the major developed markets over the last three earnings seasons. We believe this growth can continue in 2016, as both the domestic economy and the health of company balance sheets continue to improve. Margins for Eurozone firms are also growing, with overall margins for the region coming in at 6.8% in 2015.
6. The market is not expensive
Jitters in global markets tend to have a disproportionate effect on European equity markets, with asset prices falling more in Europe than the US, almost regardless of the reason for those jitters. Abiding distrust of the Eurozone recovery among investors has been exacerbated by political issues. Eurozone cyclically adjusted price-to-earnings ratio (CAPE) is well below its long-term average, suggesting potential upside in regional equities. For income-oriented investors, the MSCI EMU market offers further attractions in the form of an average dividend yield of 3.3%, compared with just 2.4% on the S&P 500.
7. The weaker global picture underscores the need to be selective
An overweight to Eurozone equities continues to make sense, considering the strength of domestic consumption, supportive fiscal and monetary policy, and relatively attractive earnings growth and valuations. But the weakness of global trade is a headwind for many sectors, and investors cannot assume that all parts of the market will move ahead in the next year.
Domestically-oriented companies, such as insurers and telecommunication companies should continue to outperform, on balance, while the materials and energy sectors will continue to be adversely affected by the slump in global commodity prices and events in China.
The companies that will gain most from the Eurozone recovery at this point are likely to be found in the small and mid-cap sectors.
European small cap firms typically source about 65% of their revenues domestically, compared to 50% for larger cap firms. The MSCI Europe Small Cap Index performed strongly in 2015, returning 20% on a total return basis, and could continue to push higher in 2016. All of this underscores a more general point for investors: it will pay to be both active and selective in 2016 and beyond.