EuroView: Quarterly Market Insight - January 2016
Rory Bateman discusses key issues facing European equities in 2016, including corporate earnings, commodity prices and political uncertainty. The final weeks of 2015 proved difficult for markets as increasing concerns about global growth, geopolitics and the first Federal Reserve (Fed) hike in interest rates impacted confidence.
- 2015 review: No re-rating for European markets
- Excess capicity across Europe could spur earnings growth
- Euro weakness set to stay
- Political risks remain heightened in 2016
Pan European equities lost 5.3% in December, leaving returns for the year as whole at 8.2% in local currency. However the 10% decline in the euro versus the US dollar (USD) left the market down 2% in USD terms.
Market volatility has continued into January, driven primarily by disappointments around Chinese growth and tensions in the Middle East.
We believe the European equity market continues to offer an attractive recovery play and, whilst emerging market growth is a concern, the self help story in Europe is intact and investors should take advantage of recent market weakness.
At the individual country level the dispersion in performance for the year was quite marked compared to the relative stability we saw in the bond markets (excluding Greece!).
Norway was the weakest market, down 6%, given the country’s high exposure to the energy sector, followed by Spain which was down 5%.
Market uncertainty in the run-up to the recent Spanish elections now seems justified given the lack of majority from any party and the possibility of fresh elections is seemingly quite high.
On the positive side, Denmark (+37%) was the strongest performer driven by the pharmaceuticals giant Novo Nordisk which appreciated by 55% over the year.
The strength of the Irish economy helped push the market up by 30% with companies clearly benefiting from the weaker euro and the structural reforms implemented post the financial crisis.
Similarly Italy (+14%) was the best performing large continental European market as newsflow around Prime Minister Matteo Renzi’s reform process improved confidence.
We have for many quarters talked about the earnings recovery potential in Europe particularly relative to the US.
Consensus earnings growth in Europe (excluding the UK) was +6.5% last year so the market appreciated pretty much in line with earnings in 2015 suggesting there was no re-rating.
We explore earnings and market valuations in detail later.
Euro depreciation was a major theme last year as quantitative easing by the European Central Bank (ECB) created euro weakness and caused the Swiss National Bank (SNB) to break the Swiss franc/euro peg. In addition the prospect of US rate increases pushed the USD higher for the second year in succession.
It’s unlikely we’ll see similar levels of currency volatility compared to 2015.
The weaker euro has been beneficial for European exporters but what happens now? Euro weakness can not continue forever and the Chinese seem ready to accept yuan depreciation.
Can European corporates continue to grow without the currency tailwind, particularly with the sluggish emerging market economies?
Whilst it’s dangerous to categorise all emerging markets together, the impact of declining commodities has been negative across the board and our bottom up analysis of the demand/supply dynamics continues to look bleak for the listed producers.
Energy and miners fall into the ‘value’ category which is now trading at an all time high valuation discount to ‘quality’.
We believe understanding and exploiting the opportunity here could define investment performance for 2016.
Finally, the EU referendum in the UK is a major event particularly given the polls would suggest there is little difference between those in favour of an exit versus those who would prefer to stay in.
The lack of a clear consensus one way or the other is likely to hang over the UK equity market.
This 2015 summary identifies a number of factors that will shape European equity market performance through 2016. Some of these factors can be considered headwinds to performance but overall we see a reasonably positive outlook for European equities, particularly relative to other geographies.
We now explore these themes in a little more detail to help us identify the key opportunities in the months ahead.
Where next for corporate earnings growth?
We have talked repeatedly about the potential earnings recovery in Europe given the lack of recovery in margins post the financial crisis, especially when compared to the US.
The familiar charts below show the margin and forecast earnings differential between Europe and the US.
Eurozone earnings growth at around 10% last year surpassed the low single digit S&P growth.
As discussed previously the weaker euro was a significant contributor to this growth but we continue to believe there is excess capacity across many industries in Europe which will be better utilised over the coming months, resulting in profit margin expansion.
The continuing, albeit low growth, economic recovery in Europe should provide a reasonable backdrop for operational and financial gearing to drive corporate profitability.
Will foreign exchange volatility continue?
Mario Draghi’s quantitative easing programme has had significant beneficial effects for European exporters given the resultant weakness in the euro.
The chart shows US dollar appreciation by 23% over the last two years (10% in 2015) versus the euro which roughly implies an uplift to European earnings of around 10%.
Whilst the trajectory of US rate increases is very uncertain, the extremely loose eurozone monetary policy looks here to stay for the foreseeable future, suggesting the weaker euro may well be here for a while yet.
However further significant euro weakness seems unlikely which means the currency tailwind for corporates will diminish as we go through the year.
A strengthening dollar has negative implications for the emerging markets given many operate a peg exchange rate system.
After the debacle last summer, China looks set to operate a steady depreciation policy of the renminbi vs the dollar, whilst some are anticipating a Saudi riyal devaluation given the collapse in the oil price.
Currency moves are notoriously difficult to anticipate and their impact on equities even more so. The SNB surprised the market in January last year which was followed by the Chinese devaluation in August.
There may well be unpredictable swings in exchange rates but overall we view current levels as reasonable and think it’s unlikely we’ll see similar levels of volatility compared to 2015.
What are the prospects for firms exposed to commodity prices?
The sell-off in global markets we have seen so far this year is at least partially due to the weak manufacturing data seen in China.
The purchasing managers’ index (PMI) survey data in December was weaker than expected and has been contracting through much of 2015.
There’s little doubt that China’s manufacturing sector and corporate profits are under significant pressure but there has been some improvement in the services sector, which is an encouraging sign as the country makes the much needed transition from manufacturing to consumption.
As we discussed extensively in the Q3 2015 write-up, less than 10% of EU exports go to China so whilst the industrial slowdown is relevant, a continuation of the intra-European trade recovery is significantly more important to the health of European corporate profits.
For the emerging markets more generally, the end of the so-called ‘super-cycle’ has generated a collapse in commodity prices and consequently the listed mining sector in Europe has been an extreme laggard.
The stockmarket has quickly priced in the negative earnings for the mining companies and the associated balance sheet effects with companies such as Glencore and Anglo American down more than 70% last year.
The question now is how much further pain could there be for commodities and when the mining sector will offer an exciting investment opportunity.
In short we believe 2016 will continue to be a difficult year for the mining companies as commodity prices remain under pressure from sustained oversupply, especially iron ore and copper which are the key drivers of earnings for the sector.
As shown in the chart below, following the greatest boom of the last century, iron ore prices have now reverted back to 100 year long-run averages, which is a level nearly 80% below the peak seen in 2011.
This correction has been due to a combination of factors, including slowing demand growth from the main consumer – China – and a substantial increase in new mine supply as the mining companies responded to record high prices by approving new mines.
The market for iron ore is now struggling with too much capacity, and we see a risk of prices falling even lower over the coming year as low cost supply continues to expand.
In copper we have similar concerns.
Although there are some structural factors supporting higher prices, we still see downside risks given that growth in new mine supply looks set to outpace the modest demand growth.
As is also the case for iron ore, China accounts for more than 40% of the world’s copper consumption, and here demand growth has fallen considerably versus the double digit annual growth seen in recent years.
We are far more sanguine and continue to believe that European equities have decent prospects.
We expect these lower commodity prices to continue putting downward pressure on the earnings of European mining companies, forcing them to cut dividends and address increasingly extended balance sheets.
The focus on cost cutting will have to continue, despite the considerable progress already made.
Investment in new capacity will be curtailed even further, with capital expenditure levels set to fall another 20% this year, representing a 60-70% decline from the peak seen in 2013.
This focus on cost savings and lower levels of investment will clearly have negative implications for the suppliers into the mining industry, with pressure set to remain on those companies providing equipment, consumables or services to the industry.
For us to take a more positive stance on the sector, we will be looking for evidence of more meaningful cuts to production as a sign that commodity markets are closer to rebalancing.
Until this happens, we remain concerned that commodity prices are at risk of further declines, preventing a stabilisation or improvement in earnings for the mining sector.
Equities: can value close the gap to growth?
The relative performance of value versus growth has reached all time relative lows in Europe and lows excluding the dot com era in the US.
The value index represents 220 stocks based on the lowest price to book, price to earnings and dividend yield in the broad MSCI Europe benchmark.
The growth index has 258 constituents selected for their growth characteristics including forward earnings per share growth, sales growth etc.
The charts below show both value versus growth for Europe and the US.
The investment opportunity in making the transition from growth into value maybe significant at some point but it’s important to understand valuations and possible structural differences between the various constituents.
For example, value can remain value for a very long time if the industry or a specific company faces extreme competitive pressures and hence remains a ‘value trap’.
In addition flows and momentum can ensure the market favours a growth or value theme for an extended period, particularly given the ever-increasing demand for passive products – the TMT (telecoms, media, technology) bubble is the familiar example.
Growing companies typically have pricing power which investors are prepared to pay up for in a very low inflation or deflationary environment.
There are some signs of wage pressure in the US with unemployment now at lower levels compared to history.
Therefore there may be some pressure on bond yields as inflationary pressures increase in the US but the flipside is developed markets are importing deflation from the emerging markets as economic activity slows in these manufacturing based countries.
From a valuation perspective, European value appears attractive on a price to book measure as shown in the chart below.
However, broadly speaking, growth has delivered earnings growth over the last five years versus value which has faced significant downgrades; for example in the banks and materials sectors.
One prominent feature of previous turning points has been a catalyst for change.
These are often impossible to predict but for example better-than-expected global growth may propel the earnings of value companies given the high operational or financial gearing.
From our perspective as bottom-up stock-pickers we believe value opportunities will emerge on a stock-by-stock basis driven by valuation anomalies relative to highly rated growth companies.
This is a gradual process which will probably change the shape of our portfolios over the coming months.
What are the potential political risks for 2016?
The Spanish market was the weakest of the major Europeans in 2015 and things continue to look uncertain. It seems probable that there will be a re-election with a weak majority coalition after that.
Austerity and the reform process in Spain have been quite successful and GDP growth has been stronger than any other major developed economy.
As a result the likelihood of an extreme party gaining a majority would seem doubtful although this definitely remains a risk for eurozone cohesion.
Threats to eurozone cohesion have also come to light given the immigration crisis.
Whilst the humanitarian debate around immigration and the political response to terrorism are beyond the remit here, the pure economics around both issues are difficult to comprehensively assess.
The end of the so-called ‘super-cycle’ has generated a collapse in commodity prices and consequently the listed mining sector in Europe has been an extreme laggard.
In the short term, both absorbing the migrants and the tourism impact of the Paris attacks are undoubtedly negative for the associated economies.
However migration and the increased fiscal spending on security in the medium term could be considered beneficial for activity.
What is clear is that there is little appetite with eurozone countries for further austerity and the fiscal purse strings overall may well be loosened creating more of a tailwind going forward compared to the quite restrictive conditions of recent years.
The biggest Pan European equity risk for this year or 2017 at the latest is the UK’s EU referendum.
We are in the process of engaging with UK companies that have trade exposure with Europe to try to gain a better understanding of how their businesses would be impacted in the event of a UK exit.
The political arguments for in/out are discussed daily but there remains little factual based evidence to help make a decision and Prime Minister David Cameron’s announcement that ministers can vote independently of the government will only add to the uncertainty.
The problem for the UK stockmarket is that this uncertainty could deter new investors from allocating capital to UK stocks.
The potential lack of demand may well create opportunities at the individual stock level and we will exploit these anomalies as best we can.
Overall however, irrespective of the outcome, we hope to have a deeper debate very soon and for the vote itself to be completed as quickly as possible.
Conclusion: despite the challenges, European equities offer decent prospects
We have discussed a number of high profile issues in this review, many of which can be construed as potential headwinds for the European equity markets.
Overall however we are far more sanguine and continue to believe that European equities have decent prospects, especially compared to many other regions of the world.
The underlying European economy continues to recover - albeit slowly – with the consumer surveys and services PMIs at their highest levels for a number of years.
For European corporates the margin expansion story is only just beginning to play out.
In the last review we talked extensively about the intra-European consumption opportunity driven by improving confidence instilled by the ECB’s quantitative easing programme.
This is very much intact as we can see from consumer spending data and bank lending surveys. In addition lower energy prices are gradually feeding through and wages are increasing for the first time in a number of years.
Perhaps most importantly we believe expectations are currently quite realistic.
Consensus GDP growth for 2016 in Europe is around 1.5% and earnings growth for MSCI Europe is expected to see mid-single digit improvements.
There are clearly significant risks ahead, particularly in the geo-political sphere, but through a combination of robust corporate earnings growth and a modest re-rating we can see European equities generating positive returns this year.