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Does political risk outweigh earnings growth in Europe?

Commentators give their opinion on whether investors should focus on the earnings growth or political risk heading into 2017.

Jonathan Jones

By Jonathan Jones, Reporter, FE Trustnet
Wednesday February 15, 2017

Europe is the “single riskiest market” heading into 2017, according to the Walker Crips’ Alpha: r² team, who say the fragility of the European Union and the euro make it unappealing.

The decision by the UK to exit the European Union is just the latest in a series of crises affecting the economies of the eurozone and is an example of one of many challenges European markets have experienced in recent years.

European equities have performed relatively poorly over the last five years, returning 68.74 per cent – 31.14 percentage points behind the wider global index.

Performance of indices over 5yrs


Source: FE Analytics

However not all agree, with BlackRock Investment Institute having recently argued that potential earnings growth makes the region undervalued. Below FE Trustnet looks at the reasons for both.

While many suggest Europe could be in line for a rebound, with economic growth returning to the region, the Walker Crips managers remain unconvinced.

“There is a not insignificant risk that the EU might break up,” portfolio manager Gary Waite said.

Fellow manager Andrew Morgan added: “There’s a calendar of events that is happening this year where Europe is the single riskiest equity market.

“This year with French elections, German elections, major uncertainty in Italy with their banking system, I believe the Greece bailout and problems with the eurozone is not even remotely solved and will rear its head at some point again soon.”

The biggest area of concern is in France, he says, where National Front leader Marine Le Pen remains in contention for the presidency.

Rowena Geraghty, EMEA sovereign analyst at Standish, a BNY Mellon Company, added: “In 2017, France will hold national elections that are likely to replace the current socialist government, a stalwart backer of the euro and ongoing European integration.”

The current frontrunner is François Fillon, but scandal around him employing his wife has threatened to derail his bid for the presidency.

Morgan said: “I think the French situation particularly is deteriorating quite sharply at the moment. The favourite, right of centre, candidate is now mired in personal scandal.

“He was the frontrunner, the saviour from the National Front and now he’s up the spout essentially with his personal arrangements with employing his wife. If he’s off the scene then a left field event is possible.”

If this were to happen, he says this would be a major threat to the integrity of the EU and of the euro. 

“The euro is essentially a political project and the signs that the EU is fragmenting would very swiftly translate into the euro fragmenting in my opinion.”

Waite added that while the UK has already voted to leave the EU, it is in a stronger position that continental Europe.

“Even the UK has got its own issues with Brexit and the triggering of Article 50 and the rigmarole going on there with the vote but at least it’s got its own currency, it has its own fiscal and monetary policy which makes it a safer bet than Europe in terms of what we are trying to do,” he said.

This, along with German and Dutch elections, the potential for problems in Greece to return and the issues surrounding the Italian banks mean Europe is a risky proposition for investors.

“You’ve got all these things going on within Europe and in terms of investable markets where would you place your bets, where would you want to place your ability to add value it won’t be Europe,” Waite said.

However, not everyone agrees, and Richard Turnill, global chief investment strategist at BlackRock has recently upgraded the region from neutral to overweight.

“We see European stocks as big beneficiaries of the broadening global reflationary environment and believe investors are too sceptical of the region’s prospects,” he said.

“The economic outlook is picking up. Our BlackRock GPS gauges show the U.S.-led bout of reflation leading to stronger growth outlooks globally.

“Recent upside surprises in European growth and inflation confirm the positive GPS signals. We believe European equities should benefit in such a reflation scenario, absent any other shocks.”

European equity earnings growth estimates 2011-2017


Source: BlackRock

Indeed, as the above graph shows, this year may well be different to the last five years, when analysts have repeatedly slashed their earnings estimates throughout the course of the year.

This year, so far, has seen many upgrading their estimates thanks in part to a late upward trend in 2016, with cyclical sectors expected to be one of the biggest beneficiaries from improving global growth and a weaker euro.

“European earnings have historically been more sensitive to global economy pick-ups than U.S. counterparts, given European firms’ lower margins and large revenue exposure to global and emerging markets, our analysis shows,” Turnill said.

“Yet economic and political shocks have kept investors overly cautious toward European equities, in our view. We believe the political risk priced into European markets around upcoming French and German elections is overstated.

“A likely Italian election may prove to be a populist flashpoint, but the major risk to our view is that a global slump cuts short the reflation trend. Our GPS data imply this is an unlikely scenario in the near term.”

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Data provided by FE. Care has been taken to ensure that the information is correct, but FE neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

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