First and foremost, the European economy is growing at a healthy pace of around 2-2.5% per year. Although growth has slowed slightly this year, unemployment continues to fall, particularly in Spain and Italy, and wages are growing which encourages consumption. Youth unemployment is not quite at its 2007 trough but it is improving significantly.
Our positive macro outlook extends to the Italian economy, widely regarded as one of the weaker parts of the continent. We acknowledge that the government in power is populist, which could generate risks, but the underlying economics are good. Italy is running a current account surplus, a primary budget surplus and has one of the highest savings rates in the world. In addition, the northern Italian states are particularly wealthy, with strong export markets.
Since the global financial crisis in 2008, European stocks have lagged those in the US. While the US market is approximately 50% above its peak level in 2007, Europe is still around 20% below its previous peak. This differential can be largely explained by the eurozone crisis of 2010-12, which led to a deep recession in countries including Spain, Italy, Portugal, Greece and Ireland. So it is only in the last five years that we have seen the recovery in Europe begin to take place.
We believe that the eurozone is now firmly on the mend and that there will likely be a ‘catch-up’ trade with US equities which will largely be earnings driven. Underlying earnings growth in Europe is now at 8-10% per year and we expect this to continue. There are pockets where we see particularly compelling opportunities. Automobiles and construction, for example, are recovering from very depressed levels and we are now two years into what we believe will ultimately be a long expansion cycle. We are encouraged by the potential and the amount of time that these sectors have to grow.
It is a commonly held, but erroneous, belief that European equities are solely exposed to the underlying European economies. Certainly, domestic earnings from Italy, Spain, Portugal and Ireland, as well as very good investor growth in Germany are important underlying sources of revenue growth, but Europe offers investors a great deal more than that. In actual fact, almost 40% of revenues derive from outside of Europe, namely the emerging markets. So European equities offer investors exposure to some of the most dynamic, fastest growing parts of the global economy, which we believe will be a driving force of earnings growth over the next decade.
Of the earnings that come from emerging markets, a large chunk comes specifically from China. Volkswagen, for example, entered China in 1986 and is the country’s largest manufacturer of cars. In the late 1980s / early 1990s, every car in Shanghai was a Volkswagen Passat – because that was the only option. Volkswagen is not anomalous. Indeed, many European companies entered the emerging markets very early and have retained a strong presence. As a result, there are some very big, profitable European companies operating in China.
In our view then, the combination of a recovering Europe, an overdue ‘catch-up’ trade with US equities and secular growth in the emerging markets demonstrates that European equities have a great deal more to offer than is often assumed. We believe that the long-term economic and corporate prospects for the region, including several years of strong earnings growth, are good and we expect to see European markets prosper.