Optimism on European equities is growing. A recent Merrill Lynch fund manager survey showed that 63% of respondents expect to be overweight Europe this year, up from only 18% a month ago, and a record in the history of the survey.
Several factors have helped to propel European equities this year. Economic data has improved, the ECB has launched sovereign QE, helping to weaken the euro, and flows into European equities have been very strong; one estimate suggests that as much as $40bn flowed into European equities in Q1 2015.
“Our belief is that much of this flow has been fairly indiscriminate, typically using passive instruments. This presents a danger for markets if, as seen in 2014, expectations for better growth and earnings are not ultimately met. We therefore believe that it is extremely important to utilise active management to gain exposure to European equities”, point out Dan Ison, Senior Portfolio Manager at Columbia Threadneedle Investments.
Moreover, an active approach allows investors to be selective and focus on the beneficiaries of QE and a weaker currency, such as dollar earners. “In our portfolios we have been emphasising areas such as aerospace, auto original equipment manufacturers and auto supply stocks, and pharmaceuticals, all of which have benefited from FX tailwinds”, said.
Healthy economic indicators
Looking forward, Columbia Threadneedle Investments expect to see earnings and economic growth expectations firming during the year. Many economic indicators are showing healthy signs, such as purchasing managers’ indices, retail sales and car sales. Meanwhile unemployment is falling and real wages are starting to rise.
On the corporate front, European earnings revisions have just turned positive. This is first time this has happened since January 2011.
The consensus GDP forecast for the eurozone has been upgraded from 1.0% to 1.3%. While there is little room for disappointment, this could be the first year of upgrades since 2010.
Encouragingly deflation fears appear to have peaked and we are starting to see signs of structural reforms in two of the laggard countries in the eurozone, Italy and France.
Current credit growth, if annualised (€120bn) would produce a 1.2% boost to the eurozone economy. Such is the level of operational gearing in European corporates that this could quite easily take our earnings growth numbers up to 15-20%.
Attractive equity valuations
While the strong move in markets so far this year suggests a lot has already been discounted, said Ison, European equity valuations are not unattractive, particularly when they are com- pared to fixed income and cash.
The European market is still yielding more than 3%, compared with zero or negative rates for some investments, such as short-dated government bonds. Additionally, should we start to see nominal growth rates improve in the domestic economies of Europe, there will be further operating leverage which should drive European profits much higher in the next few years, against a backdrop of static or falling earnings in many other regions of the world”, believes the Threadneedle´s expert.
“The main risk to our positive outlook (apart from the possibility of higher interest rates in the US and UK) is if energy prices recover and put upward pressure on European inflation. This would begin to remove the justification for QE in Europe and so raise the spectre of policy tightening by the ECB. That would cause a rise in European bond yields and a fall in equity prices but such an outcome does not look likely any time soon”, concluded.
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