12 February 2018
The 12% return of the MSCI Europe index during 2017 does not really reflect the true performance of European corporations. Given that nearly half of the revenues of European listed companies are derived from outside of Europe, it is perhaps a more objective barometer to measure performance in US dollar terms. On this basis, MSCI Europe ex-UK delivered a total return of 28%. This is a bumper year by any standards, so it seems reasonable to ask whether we have already seen a peak in returns for the current cycle.
In our view, the answer in relation to European equities is an emphatic “no”. Since the market bottom in 2009, US equities have delivered double the returns achieved by their European peers. Similarly, European earnings remain over 30% below their peak levels of 2007, while US earnings surpassed that high in 2011 and are now almost 40% above their 2007 peak.
Furthermore, from the equity market peak of October 2007 to the end of 2017 the total return of the MSCI Europe Index in US dollars has been less than 20% equating to an annualised return lower than 2% per annum; over the same period the total return for the S&P500 was in excess of 110% equating to an annualised return of nearly 8% per annum. So it is hard to argue from a longer term – or a cycle to cycle perspective – that European equities are ‘extended’ and there is substantial scope for a further catch up.
Double disaster, double dip
We believe the reason for this differential can be largely explained by the eurozone crisis of 2010-12, which followed hard on the heels of the 2008 Global Financial Crisis (GFC). From the trough in equity prices of March 2009, the US has, therefore, enjoyed a far smoother recovery. But the position of the eurozone has transformed since 2015 with balance returned to current accounts and large improvements in competitiveness and government budgets. If we believe that the eurozone is firmly on the mend – which we do – then the ‘catch up’ trade with US equities should be earnings driven. Indeed, the positive news for European equities is that earnings are now beginning to grow again in Europe with double-digit earnings growth forecast for the MSCI Europe index for both 2017 and 2018.
It became clear through the course of 2017 that the underlying Eurozone economy was growing far more quickly than many commentators and economists had expected at the beginning of the year. Central banks, supranational financial / economic bodies and economic forecasters increased their estimates of Eurozone GDP for 2017 and 2018 several times throughout the course of the year chasing the economic momentum upwards. Towards the end of 2017 contemporaneous economic indicators such as PMIs, consumer confidence and construction confidence recorded some of the strongest values this cycle while ‘harder’ indicative indicators such as car sales and unemployment figures all exited 2017 at very strong levels, indicating that this strong momentum is continuing. The Eurozone economy has been expanding since the end of 2013 but, in its fourth year, this recovery seems to be accelerating. What is going on?
In trying to address this question it is worth recapping on what happened in the eurozone economy in the years leading up to 2007 and what caused the GFC to trigger a series of rolling eurozone crises that took the best part of six years to resolve. The current account position of eurozone economies – and in particular relative to each other - is perhaps the most important; in a fixed exchange rate mechanism with no exit procedure and no fiscal transfers it is not possible to run large imbalances relative to each other without the continuous support of the banking system in intermediating flows from surplus to deficit countries. But this is precisely what happened for much of the period from 1999 to 2007, with truly toxic effects.
The positive, however, is that time and hard work heals most ills and the position of the Eurozone by 2015 was largely transformed with balance returned to current accounts and large improvements in both competitiveness and government budgets. Structural reforms in economies such as Spain, Italy and more recently France have also had a positive impact. The final piece of the jigsaw has been the recent transformation of the European banking system.
So what’s next? The eurozone crises have clearly taken a heavy toll on many of the eurozone economies. If real GDP had followed its 1995-2005 trend economic output would have been massively greater over the past decade. But this ‘slack’ can only be considered a good thing in terms of measuring the potential to catch up. As European earnings remain 30% below the peak levels of 2007, renewed economic momentum should drive a continuation of the strong trend in earnings growth.
Valuations remain depressed
The valuation of the European equity market is no longer as cheap as it was during the Eurozone crises yeas of 2012-13, with a prospective price earnings ratio of approximately 15 times the MSCI Europe index. However, the earnings power of the European equity market is still depressed versus historical levels and with growing economies and expanding earnings we believe it makes more sense to consider the European equity market on ‘normalised’ earnings basis; this suggests that European equities are still moderately valued and by no means expensive versus history. The catch up trade should have much further to run.
Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.