Hurdles exist, but stars are beginning to align
European equities have put money managers in a quandary: While the stars are beginning to align from an economic and continental politics standpoint, concerns remain over the U.K.'s exit from the European Union and divergences in growth between individual countries.
European stocks have taken a battering in recent years as a result of economic and political developments. The MSCI Europe index returned -0.4% for the year ended Dec. 30, 2016, following a -2.84% return in 2015, in U.S. dollar terms. That compared to a return of 11.96% for the S&P 500 in 2016 and 1.38% in 2015.
But Europe now appears to be steaming ahead. For the year through July 18, the MSCI Europe index is up 18.07% vs. 11.12% for the S&P 500.
"So far this year, European equities have been caught between the crosswinds of improving economic data and reduced political risks in (the) eurozone on the one side, and indications from the European Central Bank around the removal of ultra-loose monetary policy on the other side," said Michael Spinks, London-based co-portfolio manager on the Investec Diversified Growth Fund and co-head of multiasset at Investec Asset Management. "This has resulted in a bumpy ride for the Eurostoxx 50 index this year, which rallied by 11% by late April before losing about half of these returns through to the end of June, although this volatility has not put off investors," he said.
Data from EPFR Global show net inflows into European equities strategies of $23.1 billion for 2017 through July 12 — a significant turnaround from almost $100 billion in outflows last year.
On a roll
Sources highlighted first-quarter earnings from European companies and improved economic data for the region as reasons to be cheerful.
"The European economy is improving on all metrics and this is reflected on earnings expectations," said Frederic Guignard, European equities fund manager at Aviva Investors in London. "Europe is growing at its fastest pace in six years" and is posting faster growth than the U.S.
On top of that, investors have been cheered by good political news, following the election in May of Emmanuel Macron as the new French president.
"We are seeing an increase in interest in investing in Europe from both investors in the region and outside," said Paul Quinsee, global head of equities at J.P. Morgan Asset Management (JPM) in New York.
Last year, some clients were telling Mr. Quinsee that "Europe was uninvestable because of politics," and a number of investors had given up on Europe. "But since then, first of all on the political side, investors are a bit less worried than they were, with some positive surprises in Europe. The underlying profitability of companies in Europe is improving in a meaningful way — it's the first time in several years (we have been) able to say that," Mr. Quinsee said. But interest is still at an early stage, he added.
Cheap valuations relative to U.S. equities continue to be a draw, but how long remains is a question. The issue of the U.K. exit from the EU – or Brexit – is another roadblock.
"The relative outperformance of Europe over the U.S. has stopped (and reversed) when the election of (Mr.) Macron was secured," said Lukas Daalder, chief investment officer at Robeco in Rotterdam, Netherlands, in an email. "Positive elements are lowered political risks, cheap valuations and the current relative strength of the European economy. To counter, there is the growing mess called Brexit (which will be painful for both U.K. and Europe), the high earnings growth expectations and the general disbelief that the current string of strong macro data can continue much longer," with Europe normally following the U.S. by a delay of one or two quarters, said Mr. Daalder.
Structurally, executives at Robeco expect the undervaluation of Europe to lead to an outperformance in the longer run, but with the "combination of a strengthening euro and too-ambitious earnings expectations, we do not expect any miracles in the short run," he said.
Concern that the trade may be part way through playing out was shared by David Vickers, senior portfolio manager at Russell Investments in London. The firm has been favorable on Europe for "quite a while (and) what you're seeing now is, from our point of view at least, the evidence of a prognosis coming through."
Mr. Vickers' personal view is that the good story continues to play out, "but my very cynical view is you need to invest prior to that to get the gains" rather than waiting for the evidence. While newcomers to European equities "probably haven't missed" all the upside, they probably have missed a fair bit of it.
Mr. Macron's victory in France removed a "political hurdle which people had rightly so been concerned about," meaning investors "could get more positive about Europe unfettered by political drama," Mr. Vickers said.
However, future potential political drama cannot be ignored, with the potential for Italian elections next year. "At the minute at least it is very unclear as to how that plays out," said Mr. Vickers. "But we are not changing position yet." Executives are not viewing upcoming German elections as a concern.
Eaton Vance (EV) Management (EV) had also moved early, investing in European equities in what was a contrarian view. However, over the last six months, Edward Perkin, chief equity investment officer in Boston, said that view now "feels more consensus. It's been the right call but has been popular — and I don't like to be with the crowd."
Mr. Perkin said inflows continue, and the firm remains overweight Europe as executives still see better real value vs. the U.S. "But what concerns me now is (it is) no longer about valuations being cheaper — the logic is the European economy is earlier in the business cycle, so (there is) more of an earnings uplift for European corporates than U.S. I think now the burden of proof lies with reality, and the economy does need to improve, earnings do need to go up — it is no longer good enough just to bet on the hope of that happening. In order to justify the increased popularity, it has to come through," he said.