European equities made a modest start to 2017, before absolute and relative performance picked up in March. Since bond yields began to trend higher last summer, the region’s equity markets have significantly lagged many of their peers in overall terms. This political risk premium in European equities, and to some extent government bonds, presents investors with a compelling opportunity.
The irony is that despite political turbulence, Europe’s fundamental investment case has improved. While short-term equity performance tends to be driven by sentiment, improving fundamentals have historically supported gains over the longer-term. Unemployment is falling and, given its elevated level of just under 10 per cent, there is room for further improvement. Inflation has also moved into a higher range, reaching 2.0% in February. Both of these developments signal that demand is picking up relative to capacity - a reversal of the situation many economists believed had become entrenched in the region.
The ensuing recovery is also broad-based. Retail sales are firmly in positive territory, suggesting increased consumer confidence, while industrial production continues to improve as Europe’s order books fill up. Corporate earnings prospects are responding in kind, with earnings expectations moving sharply back into positive territory after a period of decline from late 2015. Valuations are also appealing, with a forward price to earnings ratio of 14.3 times for European equities compared with 21.7 times for the S&P 500.
Unsurprisingly, political risk remains the main source of investor caution towards European equities. Fund flow data shows that many US investors have fled the asset class, stung by euro weakness and an unedifying political calendar. It is difficult to sound sanguine on Europe’s politics without appearing complacent, even when the arguments are reasoned. If nothing else, 2016 demonstrated that the unexpected can and does happen.
France is arguably the most proximate source of investor anxiety, but there are three firebreaks which should prevent a “Frexit” from the euro zone and a breakup of the single currency. The first is the entente republicaine nature of French politics. While the National Front’s Marine Le Pen is ahead in some polls and likely to pass the first round of the presidential vote, her ultimate victory appears unlikely. The bulk of non-Le Pen voters are moderates who are likely to choose whoever remains out of candidates Emmanuel Macron and François Fillon, while supporters of the far Left can probably be counted on not to switch to the National Front candidate.
Even if this assessment proves incorrect, the popularity of the single currency in France must also be taken into account, with the approval rating for the euro around 70 per cent. Any referendum called by Marine Le Pen on the issue would surely result in defeat. Furthermore, a National Front victory in the parliamentary election would require an enormous upset.
French bond and equity markets are responding differently to the perceived political risks, providing some reassurance for investors. French government bond spreads are widening over their German equivalents but French equities are holding up well. The explanation lies in the composition of each market’s investor base. Most French government bonds are held by overseas investors – particularly from Japan – while most French equities are held by domestic investors. It seems that locals are more confident of a benign outcome than outsiders.
At its most simple, the compelling European trade is to hold equity indices, such as the EuroStoxx50, Stoxx600 or CAC40, all of which appear to be trading too cheaply relative to improving fundamentals. French government bonds appear particularly attractive, abandoned by international lenders in spite of the ever-vigilant backstop of the European Central Bank. Investors must, however, be conscious that even if the risks of unfavourable electoral results in Europe appear relatively low, the ensuing fallout of a break-up of the euro zone would eclipse that of Brexit or Donald Trump’s presidential victory. Even if the perceived electoral risks for Europe this year are lower than they were for Brexit and the US election, they do not invalidate the need for portfolio diversification and compelling idea generation elsewhere.