Investors may be focusing too much on the headwinds facing European equities and should consider the potential upside for the region in 2017, according to Stephen Macklow-Smith, head of European equity strategy at JP Morgan Asset Management.
European stocks have been relatively poor performers over the past few years, with ongoing political uncertainty surrounding the future of the European Union and slow growth hindering returns.
Indeed, over the past three years the MSCI Europe ex UK index has underperformed the MSCI World by 31.59 percentage points.
Performance of indices over 3yrs
Source: FE Analytics
Many have warned that further uncertainty surrounding Brexit negotiations, general elections in key European economies and other challenges could mean European equities investors are set for another disappointing year.
Among them is Rathbones head of multi-asset David Coombs who in a previous article sounded a particularly cautious tone on Europe. While admitting there are some strong European companies, he remains unconvinced that returns will warrant the risk that UK investors must take from a currency and political standpoint.
“I’m not saying that we won’t get pockets of excitement every now and again with some decent data points in a few countries but I think because we don’t know what the political agenda is going to be over the next two to three years I would look at the current data with an element of scepticism and nervousness,” said Coombs.
However, Macklow-Smith says few are contemplating what how markets might react if those problems are overcome – something he says has a more than 50 per cent chance of happening.
The first area to look at is the potential political upheaval that many investors are worried about, particularly in France, which Macklow-Smith says us one of the biggest areas of concern.
“I think that a lot of the negative expectations about politics are founded on the notion that opinion polls are wrong and that populism is going to sweep all these elections but there’s a problem with that in that last year opinion polls were largely right,” he said.
“In the UK referendum they were correct – and certainly within the margin of error. The last polls before the referendum indicated a narrow victory for leave and that’s exactly what we got.
“In the American elections, Mrs Clinton right up until the end held a narrow lead within the popular vote and that’s exactly what she got – it just didn’t map onto the electoral college. So I think opinion polls are far more useful than people give them credit for.”
In France, Marine Le Pen is polling for a victory in the first round of voting, but Macklow-Smith says few investors are aware that there is a second round which she is unlikely to win.
He said: “I think a lot of the investing public would read an opinion poll saying that Marine Le Pen is in the lead in the first round and think that it automatically means that she will win the presidency – not realising that there is a second round where she will run off against the strongest candidate.
“And when you look at the National Front’s ability to move from victory in the first round to victory in the second round there is an almost insurmountable hole for them to climb. Centrist voters are quite happy to club together across the left-right gap in order to keep out the National Front.”
In the Netherlands, he says that even if Geert Wilders’s Freedom Party win they will struggle to form a government, while Germany’s Angela Merkel remains the strong favourite to form another coalition government in September.
“Far from ending the year with three populist governments, we may well end with none,” the strategist said.
With political risk overdone, Macklow-Smith says the rhetoric should focus on earnings growth and inflation – two areas that could drive returns in 2017.
“It’s already better than you think it is in Europe. Inflation is recovering, so nominal growth is picking up,” he said.
“Company revenues are a nominal rather than a real measure, so the relief in pricing pressure is good for margins and good for earnings.”
Source: Eurostat
The strategist says he is “100 per cent confident” that nominal growth will occur in 2017, with real growth at relatively stable levels but a pick-up in inflation boosting company operating leverage.
“And with job creation looking pretty healthy, job creation falling, you’ll see this feed through to wages and that then in turn feeds through to consumption,” he added.
All this means suggests that if investors are willing to accept earnings estimates of around 8 per cent, and a starting dividend yield of 3 per cent, the expected total return for this year could be around 11 per cent.
However, if there is a re-rating, this could extend even higher. While the above is the base case, Macklow-Smith says a number of other factors could boost returns further.
“Return on equity is much lower in Europe, but we all know the reasons why – bank write-offs coupled with dilutive share issuance, energy earnings smashed by the oil price, commodities earnings hit by metals prices in 2015, emerging markets earnings (for instance in luxury goods and food & beverages) depressed by downturns in commodity-dependent economies, autos earnings hit by ‘dieselgate’,” he said.
“Yet all of these factors are set to either moderate and turn into tailwinds in 2017.
Even Brexit could be viewed in a positive limelight for the EU, he argues. 
“One could make the case that the UK’s decision to exit the EU is actually a positive for the European project, in that it removes an impediment to further integration, since the UK has always vetoed federalist initiatives,” he explained.
“In addition, the UK has been the largest single recipient of foreign direct investment in the EU in the last ten years.
“If access to the single market is impeded at least some of that investment may well flow to the continent.”
Overall, Macklow-Smith says investors need to cut through the noise and focus on the facts surrounding Europe.
The fund manager said: “For European investors, finding viable opportunities to generate returns will require looking through the mixed headlines and ferreting out the facts.
“The fact is that a pick-up in corporate earnings, rising incomes and economic growth is within reach, and that could well filter through to the ballot box. Asking what could go right for Europe this year is not nearly so naïve as you might think.”