Since the start of the year, European stocks have been popular with investors but are still cited as a pocket of value in global markets.
2015 has seen the MSCI Europe ex UK index achieve total returns of 13.13 per cent, which is 3.16 percentage points more than MSCI World.
The index has pipped the US market to the post, which has been the darling of investors for several years, beating the S&P 500’s total returns by 5.7 percentage points. It’s also made more than the FTSE 100, but has lagged areas such as Japan and emerging markets.
Performance of indices since 2015
Source: FE Analytics
The European Central Bank’s move to launch full-blown quantitative easing sparked renewed interest in the region, as €1.1trn will be pumped into the markets over the coming months.
Meanwhile, asset allocators point out that Europe still looks cheap compared to its global peers, having been largely shunned in the years since the eurozone debt crisis.
When declaring European equities to be cheap, many commentators cite cyclically-adjusted price/earnings (CAPE) ratio. These take the price of an asset and divide it by the average of 10 years of earnings, adjusted for inflation.
Higher than average CAPE ratios suggest lower than average long-term annual average returns and vice versa.
Macroeconomic forecasting consultancy Capital Economics points out that Europe does look much cheaper than the US on CAPE ratios. Eurozone equities have a CAPE of around 15 times, while in the US they are close to the 30 times mark.
“However, its valuation is much less appealing when a comparison of standard price/earnings [PE] ratios is made – indeed, the PE ratio for the non-financial sector is actually fractionally higher now in the eurozone. This contrast reflects different paths for earnings per share [EPS] since the financial crisis,” the consultancy added.
The chart below shows how close the valuations of eurozone and US non-financial stocks are on this basis, along with the UK and Japanese markets.
PE ratios of non-financial sectors of markets
Source: Capital Economics
Of course, the relevance of this depends on how much investor trusts the individual metrics. Capital Economics said: “We don’t have a strong view about the relative usefulness of PE and CAPE ratios.”
“Equities are a claim on future earnings, so it boils down to which of their denominators is the most useful guide to a ‘normal’ level of profits that can be expected to grow over time.”
But the consultancy adds that its eurozone stock market’s relative valuation is “only quite, not very, low”.
Fund managers are also starting to point out that Europe is no longer as cheap as it once was.
The recent Bank of America Merrill Lynch Global Fund Manager survey found that a net 46 per cent of asset allocators are overweight the region. While this is still a substantial figure, it’s down by 14 percentage points from last month.
A regional sub-survey of European fund managers also found that a net 10 per cent believe European equities are overvalued. This is up from a net 3 per cent saying they were undervalued one month earlier.
Manish Kabra, European equity and quantitative strategist at BofA ML, said: “We are seeing a form of rational exuberance in Europe where a positive view on stocks is supported by fundamentals – but investors no longer believe valuations are cheap.”
In Blackrock’s Looking Glass report for Q2, chief investment strategists Ewen Cameron Watt and Stephen Cohen say they prefer European equities to the US and believe in taking a broader approach to the region.
However, they are also wary about valuations.
“A weaker euro and extremely supportive ECB have helped broaden out the recovery in Europe, from leaders such as Germany to peripherals – especially Italy,” the strategists said.
“The caveat: European equities are no longer cheap and are now more of a consensus trade. Corporate earnings growth is coming back into focus; strong growth here will be needed to justify the ongoing rally.”
Not only do Watt and Cohen warn that European stocks are now worse value for money, they also urge investors to keep an eye on the macroeconomic situation.
“As valuations rise, particularly in Europe, and as overweight positioning gets more crowded in popular trades, investors should be aware of upcoming dates that could actually be significant for markets.”
“In the eurozone, elections in Spain and Portugal may be significant, particularly with the rise of anti-austerity parties. Ongoing negotiations between the Greek government and the institutions (formerly known as the Troika) may lead to increasing momentum for such parties.”
If the strong gains of Europe in recent weeks has caught investors’ eyes, Pictet Wealth Management chief investment officer Yves Bonzon points out just how much this is a result of currency movements rather than an improvement in fundamentals.
“Ironically, much of [Europe’s] performance is a money illusion. Measured in a common currency, the performance of European indices is hardly different from other regions,” he said.
“Since 1 January, the Euro Stoxx has risen by 20 per cent in euros, but for a Swiss investor the return is only 4 per cent, or 7 per cent for a US investor, which would not even cover the exchange risk.”
“By comparison, the Swiss stock market is up 4 per cent over the same period, or no better than the Euro Stoxx measured in Swiss francs.”