Sentiment towards Europe right now is weak, whether you're an investor in Europe, in the US, or in Asia. We don't have to search hard to find out why Europe is so out of favour, to name just five: Italy's fiscal budget showdown with the EU, the interminable Brexit negotiation, Trump's tweets, weak GDP growth, or global monetary policy tightening.
It is no surprise that our conversations with investors in Asia and other markets are tilted towards the risks, rather than the potential returns. Fund flows have been reflective of investor sentiment with the flight from equities, especially Europe. The real proof is in the indices, where it is clear that appetite has evaporated: while the S&P500 is up 0.8% year-to-date (YTD), MSCI Europe languishes, down 16.3% YTD in US dollar terms. For the MSCI World index, Europe now only accounts for approximately 22%, a record low.
The epicentre of the gloom is still the UK, where about the best that can be said 30 months post referendum is that we are nearer the end than the beginning. Therefore, risk aversion is understandable. The range of outcomes, the different permutations that could prevail even now, is seemingly infinite. Even the assumed best-case outcome for Brexit is expected to shave 3.9% from GDP according to the Chancellor Philip Hammond. However, amidst all the unfavourable political headlines, not all indicators are so weak.
The UK's current account deficit has narrowed, inbound M&A has been robust, and in the first half of 2018 there was more foreign buying of London commercial real estate than New York, Paris, Frankfurt and Munich combined. UK unemployment continues to trend down, the current level of 4% over the 3 months to July is the lowest since 1975. Metrics such as retail spending, construction & ONS growth forecasts are also all improving and monetary conditions remain easy in both the EU and UK.
The UK today is just a microcosm of the broader European situation, a gradual pick-up in economic data alongside rising political turmoil. On the latter point we shouldn't really be surprised, twas ever thus.
It is important to remember that companies across Europe are conditioned to uncertainty. They're accustomed to decision making with incomplete information without the luxury of delaying investment until outcomes become more definitive. They need to stay focused on their growth strategy, whatever the external environment throws at them. When corporates are making 10-year investment decisions, the worries we have today can, on reflection, seem trivial in the grander scheme of things. The reality is that businesses adapt, innovate, and find new growth opportunities.
We can see this translated into European earnings expectations. Europe is generating growth for the second straight year. European earnings growth has consistently lagged that in the US, especially since the financial crisis, and that is reflected in the remarkable stock market returns over the past decade.
However, as Trump's tax cut annualise, the gap between European and US earnings growth will narrow materially. Both Europe and the US are expected to see around 8% eps growth in 2019, but from very different valuation levels. MSCI Europe trades on FY19 forecast 12x price/earnings, 1.5x book value, and is expected to pay a 4.4% dividend yield. On all these metrics, Europe remains far cheaper than the US (eg: S&P 500 is 14.8x FY19 price/earnings).
It's not easy to have conviction when markets are this gloomy, but as the Sage of Omaha says, "the time to be greedy is when others are fearful". We acknowledge the tail risks and we know it is hard to price the risk around the UK and Brexit, Italy and the EU. However, history tells us that European corporates can adapt. There have been new concerns every year since the financial crisis and 2019 will be no different. Ultimately, we need to separate the market from the economy. Both the UK and mainland Europe are out of favour, while quietly delivering growth, this could be a rewarding time for active equity investors.
By Martin Todd, European equities portfolio manager, at Hermes Investment Management
