Europe could be an attractive investment story this year, relying more on valuation and fundamentals and less on late-cycle euphoria.
Europe enters 2018 without the policy catalyst of the U.S., the momentum of emerging markets or the investor enthusiasm of Japan. Yet, we at Morgan Stanley Research believe that the region will not only shine this year in a surprisingly broad way, we expect EU equities to outperform other regions.
There are a few reasons we’re making this call. First, the region’s currencies will generally beat many peers in developed markets. Second, EU credit looks preferable to the U.S. or Asia. Third, Eastern Europe will likely do well relative to other emerging markets. But most importantly, in our view, the region’s positive story relies less on a ‘late-cycle exuberance’ thesis, and more on fundamentals and valuation, than elsewhere.
Let’s start with those fundamentals: Following a sustained post-crisis drought, measures of eurozone strength are strong and broad-based. Corporate confidence and investment have rebounded.
Bottom line: Europe is an attractive investment story this year, with a narrative more about valuation and fundamentals.
Consumer spending is up and unemployment is back to levels seen in 2005. The government sector has broadly completed fiscal consolidation, and replaced it with (modest) fiscal easing. The eurozone’s current account surplus has surged to 3.1% of GDP.
It is notable to us that this improvement looks to be built on a strong foundation. Consumer borrowing and corporate loan growth are rising, but off a low base. Fiscal policy is easing, but modestly. We see a strong case that the eurozone crisis (and later, emerging markets weakness) deferred a material amount of consumption and investment across the region. There is still room for catch-up.
No regional story is uniform, and I’ll grant that there are places (like the UK) that look weaker on measures of current account or consumer borrowing. But even here you have interesting offsets, which I’ll come back to shortly.
A better macro story should go hand-in-hand with a better micro story: in this case, corporate earnings.
European earnings held the ignominious distinction of falling between 2011 and 2016. A big reason: EU earnings have outsized exposure to commodities, financials and emerging markets. All three have faced large, interlocking headwinds. A lack of tech exposure didn’t help matters.
But these headwinds are shifting. Commodity earnings, led by energy, are improving. European banks have raised necessary capital and are growing earnings. And emerging markets growth is reaccelerating, a boon to the 30% of European revenues that come from the region. In a world worried about corporates ‘over-earning’ in a late-cycle environment, European earnings remain below the long-term trend, and generally haven’t been flattered by buybacks or releveraging. And after a record run for technology stocks, maybe less exposure isn’t the worst thing.
So what of valuation? Eurozone equities trade at a 19% forward price/earnings discount to the U.S., and 10% below the 30-year average of the regions’ relative multiples. The FTSE 100 is cheaper to Global Stocks versus 20-year norms than any of the 30 most liquid global equity indices we track. And comparisons of regional equities to local government bonds remain so extreme as to seem unfair.
But valuation isn’t just an equity story. The Euro remains 8% below our FX strategists’ estimate of fair value (despite good growth and the current account). The British Pound, Swedish Krona, Norwegian Krone and Russian Ruble all screen as historically cheap on the real effective exchange rate. And European credit trades at similar spreads as U.S. or Asian counterparts, despite generally better fundamentals.
Finally, we think the region holds some advantages in politics and policy. That may sound odd in a discussion of Europe, but hear me out.
On politics, we think the trickiest votes for the region happened last year (France, Germany, the Netherlands), and while Italy faces fresh elections in March 2018, a new electoral law reduces the risk of extreme outcomes. Contrast this with the U.S., where the legislation most able to unite the party in power (tax reform) is now behind us, and where key mid-term elections lie ahead. On policy, 2018 could see new leadership at the Bank of Japan and will see new leadership at the Fed. Mario Draghi’s term, in contrast, runs into 2019.
Bottom line: Europe is an attractive investment story this year, with a narrative more about valuation and fundamentals, and less about late-cycle euphoria, than in other regions.