European stocks coming back into favor

Money managers say stock picking of European equities might be back in vogue, thanks to the most successful earnings season in seven years for European corporations.

After major outflows from European equities last year, inflows have rocketed since the beginning of 2017, particularly in the past few weeks, said Romain Boscher, global head of equities at Amundi in Paris. That compares with net outflows of $100 billion in 2016, he said. Amundi has €1.13 trillion ($1.23 trillion) under management; a breakout of European equities could not be learned by deadline.

Sources said optimism on the prospects for corporate Europe is high, because of the strong U.S. dollar and cheap equity valuations. Illustrating their confidence in the region and in its companies, foreign investors in the first quarter announced a record $345 billion of planned acquisitions, including Johnson & Johnson's $29.3 billion takeover of Swiss biotech company Actelion.

Industry sources think the fresh inflows foreshadow a much stronger capital reallocation by pension funds and other institutional investors into the Continent's equity market.

According to EPFR Global, a provider of fund flow and asset allocation data based in Cambridge, Mass., flows into dollar-denominated European equity funds shot up to $6.5 billion so far in 2017, beginning an upward trend around mid-March. European euro-denominated equity funds followed suit to approximately $7 billion. Both of these types of funds temporarily saw outflows as recently as January this year.

Some sources believe that the hot European stock market could boost active management strategies overall.

“2015 and 2016 were dominated by defensive/low-volatility strategies but this year the tactics will change in favor of stock picking,” Mr. Boscher added.

With political risk seen abating on the Continent — thanks in part to the defeat of France's populist party in that country's presidential election this month — the market and its participants are now concerned about fundamentals.

Ingbert Faust, head of research at Union Investment in Frankfurt, said: “So far, two-thirds (of corporations) reported higher than expected earnings and even 80% surprised with better revenues.” Union Investment manages e300 billion, of which e18 billion is in European equity strategies.

Mr. Faust added: “Growth has picked up recently. Our GDP forecast for the eurozone amounts to 1.7% for 2017 and 2018, which is not too bad given the many challenges of the aging economies (…) Spain and France, are growing at an increasing pace. (Therefore) growth rests on more pillars than in previous years and, in effect, there is a lot of economic tailwind for European companies.”

And the positive feeling in Europe is making its way across the pond, with U.S. investors, including pension funds, said to be beginning to buy European equities — and in turn pushing asset prices up.

“There are several positive indicators such as strong global growth and increasing corporate profits — that is why U.S. investors increased their (European) stock exposure in the last weeks and the stock prices increased noticeably. Looking forward, the positive indicators are already included in the current stock prices,” said Stefan Degen, asset manager at BayernInvest in Munich, in emailed comments.

Sources said that, for the first time in a long time U.S. investors see European equities as more attractive than stocks in their own country. In 2016, the MSCI Europe index returned 0.22%, compared to its -2.3% in 2015 and -5.68% in 2014. In sharp contrast, the MSCI Europe is up 11.21% year to date through May 17 against the S&P 500's 8.05%.

Mr. Faust added: “We are currently quite positive on the stock markets in the eurozone, especially small and midcaps … When it comes to individual sectors: health care, materials, as well as consumer discretionary look attractive from our point of view.”

According to Mr. Boscher, Italian midcap stocks, in particular have offered 35% return in the last six months.

European pension funds also could be serious about shifting attention to the asset class, after stocking up on cash for some time.

Luca Paolini, chief strategist at Pictet Asset Management in London, said the trend of improved returns in European equity markets will continue, due to the expectation for the dividend yield to be in the region of up to 70% of total return — an increase from the current level of around 30% to 40%. Pictet oversees $172 billion; the European equity breakout could not be learned.

Others, however, downplayed the long-term potential of the European stock market despite positive fundamentals.

“In the short run, over a six-month horizon, we expect no further potential for the stock market. We assume the European stock market is currently in a 'sweet spot' status,” Mr. Degen of BayernInvest said in an email. “In the longer term the market is well founded. We recommend new engagements after an adjustment of the stock prices of about 10%.”