European growth is low by any standards. We expect 1.2% from the eurozone this year, in line with the latest International Monetary Fund forecast, while the fund is looking for 2.4% from the advanced economies as a whole and 3.6% from the U.S.
But while this projected performance is indeed sluggish, markets, we believe, are taking too pessimistic a view of the outlook for Europe and in particular for the 19-nation single currency bloc.
A number of current factors are positive for European growth, but the investment consensus would seem to be ignoring them, leading to significant undervaluation of eurozone equities. Paradoxically, this puts the eurozone in the position of being most unlikely to disappoint the market. Indeed, most of the likely growth outcomes would recast the market view of Europe and effect a positive transformation on the valuation of equities.
More on that in a moment.
First, what is the case for our cautious optimism on the outlook for European equities?
It rests on four major factors at work in the eurozone economy:
- lower commodity prices,
- a lift to exports and earnings from the weaker euro,
- a wave of corporate restructuring and reform that ought to deliver better margins and,
- finally, a policy stance from European institutions and governments that is generally positive for investors.
The fall in commodity prices, notably oil, brings three benefits, two positive and one which, at the risk of sounding contradictory, may be called a “negative benefit.” On the positive side, falls in the cost of energy and fuel should, all things being equal, give a lift to consumer sentiment as money saved from “distress purchases” such as gasoline is available for discretionary spending. Price declines in this area deliver a second benefit in terms of reducing the “input” cost of fuel and raw materials for industry.
The third benefit is the likelihood that it is falling commodity prices that lie behind the recent bout of deflation in the eurozone, with prices falling by 0.3% in the year ended Feb. 28, rather than a slump in demand. This is the “negative benefit,” in that it offers the reassurance that a factor to be feared — falling demand — is most likely not to blame for the very subdued inflation picture.
Demand has proved resilient and has not collapsed, as many commentators feared. But neither is it sufficiently robust to raise the likelihood that supportive economic policy measures could overstimulate the economy and spill over into inflation.
On the decline in the external value of the euro, the fall against the U.S. dollar since the second quarter of 2014 has been of the order of about 20%, which ought to be positive for exports and for corporate earnings and margins. As we shall see in a moment, the IMF identifies the depreciation of the euro as being positive for activity in the single-currency area.
The third key factor in support of our cautious optimism is what has been a largely unsung wave of restructuring inside European companies that ought to create the space within which margins can increase further. Under the pressure of the financial crisis and the recession, companies have had to become much more disciplined in terms of their cost base and their allocation of capital.
Sometimes this has been spurred by regulatory changes — the banking sector is the obvious example of this, where banks have found it more attractive to draw in their horns and focusing on home markets, where lower rates of growth are compensated by higher profitability. In other industries, restructuring has presented itself as logical and desirable, regardless of regulatory factors, and has been pursued with a vigor that has often been overlooked.
What matters is that these changes are real and are beneficial from an investment point of view.
Linked to this is a fourth and final factor, the supportive nature of the policy responses launched by European government and institutions. The most visible of these is the e1.3 trillion ($1.4 trillion) program of quantitative easing put in place by the European Central Bank in January and set to run until at least September next year.
Less high profile but equally important are the piecemeal reforms effected by a number of countries, reforms to labor markets, to tax systems, even to previously rigid structures for the working week. Unit labor costs have started to come down significantly in some “peripheral” countries, notably Spain, Portugal and Ireland, during the last five years.
From the investor’s point of view, all these factors ought to have a positive impact on margins. It is true that European margins are low by global standards and, having peaked at 9.5% before the crisis in the developed European economies, are now at about 5.5%. But while we expect them to rise, we do not expect them to do so in an orderly, linear manner.
In January, the IMF said of the eurozone: “Activity is projected to be supported by lower oil prices, further monetary policy easing … a more neutral fiscal policy stance, and the recent euro depreciation.” The IMF shared our view that the growth trend would strengthen toward the end of this year and is forecasting growth of 1.4% in 2016.
Despite all this, the investment consensus remains cool, to say the least, on the eurozone, with global investors generally staying underweight, having sold down their positions in 2014. In large part, this arises from an entrenched view that Europe is not taking action to deal with sclerotic labor and product markets, with inefficient tax systems, with structural imbalances and in general with the malaise seen to have settled over the single-currency bloc. In this view, any reforms that are put in place are ineffective and halfhearted.
This view is out of date. Put simply, it is no longer true. Current accounts for the persistent offenders among the deficit countries are moving back into surplus, peripheral economies are growing again, the money supply continues to expand and the momentum behind corporate earnings is finally turning positive.
But the deep discount on European stock markets vs. those in the U.S. suggests the good news has so far failed to get across. This can be frustrating for those keen to see Europe given the credit it deserves for its achievements and have its potential recognized. It does, however, create opportunities, given that significant positive macroeconomic news on the eurozone is likely to change investors’ views of European equities.
How likely is such good news? Well, general expectations are currently so low that meeting or even exceeding them ought to be eminently achievable.
Of course, there are political and economic events that could upset calculations. The full implications of the Greek election results earlier this year have yet to emerge, while voters will be going to the polls this year in the U.K., Portugal and Spain.
Slower growth in China could impact the European economy and there are, of course, geopolitical tensions on Europe’s doorstep.
All that said, it seems likely that only a major surprise or disappointment in macroeconomic policy or an external shock of some kind could create the conditions in which European equities prove a significant disappointment for investors.
Matthew Leeman is head of European equities at Morgan Stanley Investment Management in London.