Compared to other major developed market indices, the MSCI Europe ex UK index has lagged behind since a broader rebound began in the wake of the financial crashes of 2008. Since 2008 it is up 77.07 per cent, half the gain of the S&P 500 and significantly less than the FTSE All Share and MSCI World.
Performance of indices over 6yrs
Source: FE Analytics
The first six months of 2014 seemed to show incremental improvement in European stocks as the European index ground higher but the second half saw the index fall as investors became increasingly concerned about the Russian standoff with Ukraine, gridlock in the economic recovery and worries of deflation.
The team says as the causes of this impasse improve and the ECB launches its widely anticipated full-scale QE programme, markets will gain ground.
“Given the depressed expectations and valuations of European equities, we don’t believe it will take much for the asset class to make progress in 2015. Expectations have been reset lower and are there to be beaten,” the team said.
“We believe the ‘soft patch’ in economic data during 2014 should reverse as downward pressures on the economy continue to fade. We believe valuations assume a very negative outcome thereby providing the potential for strong equity returns if incremental progress can be made.”
“So, to us, it looks like the reasons for European equities to de-rate from here are lessening while current valuations look just too low – for example Europe is trading on a 20 per cent discount to its long-term average on a cyclically adjusted PE basis.”
The team expects earnings to increasingly benefit from a number of positive developments: the gradual pickup in the economies of Europe and its trading partners, subsiding currency headwinds and increased spending after falling commodity, debt and tax costs.
“Given that corporate earnings are 30 per cent below the peak in 2007 there remains substantial headroom for improvement,” it added.
“Given the top-down concerns equity markets have prioritised those sectors perceived to be ‘low risk’ in 2014 – examples include consumer goods, utilities and healthcare. The valuation gap between some of these areas and the rest of the market is starting to become stretched again.”
“If nothing else 2014 acts as a reminder that very rarely do markets or economies move in a straight line – either upwards or downwards. No doubt 2015 will be no different."
The team also argues that several factors suggest the European economy is in much better shape than the broader market anticipates and that it will gradually improve throughout the year, with improving sentiment not far behind.
“Government deficits are moving in the right direction. 2015 will be the first year since 2009 when government austerity measures as a whole should not be a significant drag on economic activity,” they explained.
“Indeed a number of countries both in the eurozone and elsewhere in mainland Europe have announced tax cuts of one form or another - Spain, Portugal, Italy, Finland, Norway, France, Switzerland and Denmark all come to mind.”
“We see relief coming from a number of other sources too. The intense de-leveraging of non-financial corporates is slowly abating. Exporters should benefit from the lower euro especially against the US dollar.”
They say support will come from a programme of quantitative easing, a low Euro, falling oil prices and new ECB funding at low rates.
“Consumption has steadily risen since Q2 2013 – indeed consumers are showing a greater willingness to purchase large ticket items in response to lower inflation – hardly consistent with a deflationary mind-set. The ECB has plenty of weapons available if needed – possibly even public QE – something that was considered totally off limits not so long ago,” the team said.
“The significant fall in oil costs should provide additional support to consumers as well as some companies outside the oil sector. Already we are seeing the high cost of corporate loans – of less than €1m – in some of the peripheral countries come down meaningfully. With the ECB set to provide significant amounts of new funding at very low rates, financing costs should fall further. “
They say these factors will not re-float all boats evenly and express two places where investors will see greater returns: “We believe a number of sectors provide companies with attractive valuations and are well placed to take advantage of a gradually improving macro environment: selected cyclicals, financials.”
“Overall, we find the risk-reward of the more defensive areas much less appealing - especially sectors such as consumer staples.”
Rowan Dartington’s Guy Stephens says Switzerland’s recent decision to abandon the currency peg with the euro suggests imminent European QE, but the Greek election may delay the ECB’s announcement, leading markets into a highly volatile period.
“If Mario Draghi does not declare his hand on Thursday, which is quite possible ahead of the Greek election this coming weekend, we will have all the ingredients necessary for a highly volatile period beginning next Monday,” he said.
“They may be looking to incorporate some conditions on Greece, and this could delay any announcement until after their election, as to do otherwise would attract criticism of electoral interference.”