10th November 2013
Europe has been growing more popular with investors since the economic climate started to turn over the summer. This popularity has not been restricted to the major economies of Germany and France, but has included the unloved peripheral nations such as Spain. But with valuations on these markets now higher than for the US in some cases, have investors missed their chance to reinvest? Cherry Reynard reports.
The peripheral markets of Europe have been some of the top performers over the past year. The Spanish Ibex is up 27.15%, the Italian FTSE MIB is up 23.36%. The really strong area has been Greece. The Greek Athens Composite index is 41.81% higher over the past 12 months.
Investors have started to take notice. The latest set of fund flow data from EPFR showed investors returning to peripheral markets. As trade website Fundweb reported: “A “record-setting” amount of new money was put into EPFR Global-tracked European and Spainish equity funds in the third week of October.”
Fund managers have also been returning to the region. For example, Nicolas Walewski, founder and fund manager at Alken Asset Management has seen strong returns from Spain this year. the Telegraph reported. He invested in, among assets, Spanish banks at the start of the year. He says companies in Spain are more profitable than those in Germany: “Having come so close to the edge, those corporations that are left standing have made significant efficiencies and are now looking attractive.”
However, while those that invested a year ago have done well, there is an argument that the opportunities in peripheral Europe have been well and truly discovered. The markets are now trading on price to earnings ratios higher than the much-favoured US S&P 500. For example the Spanish market in aggregate trades on 19.1x, Italy on 20.3x and Portugal on 17.7x. Only Greece still looks cheap on this basis – 5.6x.
James Sym, manager of the Cazenove European Income fund, argues that these price to earnings ratios are deceptive because earnings are so depressed. Whereas in the US, corporate earnings are at cyclical highs, in Europe they have yet to recover. He says that cyclically-adjusted price to earnings ratios are more instructive and show peripheral Europe still trading at historic lows. He also points out that the Spanish market is dominated by Inditex, the owner of the Zara chain, where strong growth has afforded it a high valuation.
He says: “Peripheral Europe has only just started to recover. Spain in particularly has got a lot better. There has been a huge change in unit labour costs and it has become much more competitive. This will feed into corporate confidence and consumer confidence – we are starting to see the start of the cycle.”
Therefore, the question for investors is whether earnings are likely to recover sufficiently to justify the higher ratings. For that to happen, economic recovery needs to take hold. Spain has taken the right steps to reform its economy. Spain, Ireland and Portugal are likely to show budget surpluses next year. There is unlikely to be a rapid snap-back in growth, but Schroders believes that countries such as Spain and Portugal are likely to show stronger growth than Europe’s core markets in 2014. The International Monetary Fund has predicted that all European countries except Cyprus will return to growth in the fourth quarter of this year.
However, the picture is not universally bullish. Walewski points out that areas such as Italy are still weak and unlikely to get better: He criticises the political deadlock, with reform made impossible by constant changes in government. He adds that the Italian market is the worst performing developed market stock market in Europe since 1945. He believes the companies that do make it onto the stock market are generally of poor quality with the country’s best companies remaining in private or government hands.
Stephen Snowden, manager of the Kames Investment Grade Bond fund agrees that Italy is still a problem area: “There is still likely to be some debt forgiveness for peripheral markets such as Italy; it is difficult to see how it can grow its way out of its debt burden with a rapidly ageing population and bureaucratic corporate sector.”
Investors therefore need to be discriminating, selecting only those markets where there is genuine change and reform. Valuations are no longer at rock bottom and the growth path must be relatively clear.
Another question for investors is whether Europe’s peripheral economies are the right place to take risk. Yes, they are poised for an upturn in economic growth, and with that an upturn in corporate earnings, but if developed markets in general are likely to recover, this will surely have a knock-on effect in emerging markets? They might see a stronger recovery than peripheral Europe and are currently trading on more attractive valuations.