There has been significant coverage recently suggesting that asset valuations, including equities, have entered irrational territory. We acknowledge that equities have performed well over recent years but would argue that European equities could have further to go.
In fact we believe investors could see a 30% market appreciation from current levels on a three-year view.
There are two key drivers to this return profile – interest rates and profit margins - and our conviction has increased over recent months. The 7% market retreat since this year’s peak in May offers an entry point, in our view.
Europe’s economy is growing but inflation still low
Firstly, from a macro perspective, there is clear evidence that the “super tanker” European economy is on an improving trend and we expect this to continue.
What’s different over recent months is that the “Trump reflation trade1” has petered out and bond yields are reverting back towards pre-Trump levels. The chart below shows 10-year US Treasuries and German Bunds where yields are heading back towards pre-election levels.
Chart 1: Bond yields declining once more
Not only is President Trump finding it extremely difficult to get reflationary policies through, but there is increasingly an acceptance that wage inflation in the developed world is simply not coming through either.
The Phillips Curve2 relationship between unemployment and inflation has broken down given “disruptive technologies” which are impacting many sectors across the market. Simply put, wage inflation is a key determinant of general inflation and, since the Global Financial Crisis, companies are taking a different view towards recruiting personnel where there are technological alternatives available.
Low inflation = low interest rates
Without inflation, there is no incentive for the US Federal Reserve (Fed) or the European Central Bank (ECB) to put up interest rates too far. Raising rates excessively will simply choke off the economic recovery that we are currently witnessing.
In the form of declining bond yields, the bond market is telling us that inflation should not be a problem in the foreseeable future. Recent data and predictions from the central banks corroborate this view.
Our view is therefore that interest rates should normalise at a lower level than we have seen in the past.
What does this mean for European equities?
The chart below shows the historic relationship between interest rates and stockmarket valuations.
In simple terms, the chart illustrates that as interest rates decline the valuation multiple on the market increases (shown by the Fed Funds rate on the left hand scale and the earnings yield – i.e. inverse of market price-to-earnings multiple – on the right hand scale).
Chart 2: US interest rates and European valuations
If interest rates normalise at a lower level, then this implies that the market multiples should be higher.
The chart would suggest that if the Fed Funds rate normalises at, say, 2%, then the implied market price-to-earnings ratio in Europe should be around 18x3 versus the current consensus forward multiple of 15.5x. This includes a 20% discount to the US market using the same analysis4.
Ongoing improvement in European profit margins
The expansion of the market multiple discussed so far only provides half the potential 30% upside. The remainder comes from profit margin expansion which we think should drive earnings per share ahead of current market expectations over the coming quarters.
We have discussed the profit margin differential between Europe and the US on many previous occasions (see our latest EuroView for more details). The eurozone crisis seriously impacted corporate profitability and it has taken a substantial amount of time for capacity utilisation in the economy to improve and for unemployment to come down.
The chart below shows the recent shift in profit margins which is driving the 12% forecast earnings growth we expect to see in 2017.
Chart 3: Profit margins in Europe are improving
We think this is the start of a multi-year process where European profit margins will eventually resume their commonality with the US. This would be consistent with the experience of the 2000s, as shown in the above chart. Operational gearing5 as excess capacity in the economy is utilised should ensure a robust earnings growth profile for Europe overall in the short and medium term.
Taking advantage of temporary weakness
In conclusion, we believe there could be much more to play for in European equities, despite the current weakness in markets induced by Korean tensions or fears around growth sustainability.
The economy in Europe is in decent shape. While there will always be uncertainties, a higher market rating driven by sustainable, low interest rates coupled with margin expansion could deliver decent returns over the coming quarters.
Please remember that past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.
A pdf version of this article is available below.
1. This refers to the expectation that President Trump would push through policies designed to stimulate economic demand, and that investors would buy assets expected to benefit from such policies.↩
2. The Phillips Curve describes an inverse relationship between rates of unemployment and corresponding rates of inflation. It says lower unemployment should correlate with higher inflation.↩
3. We can estimate the potential ‘market rating’ by asking what is the required rate of return on the market if the real risk free rate in Europe (i.e. the minimum return an investor expects) is 1% and the equity risk premium (i.e. the excess return that stockmarket investing provides over the risk free rate) is 3.5%? This ‘earnings yield’ of 4.5% implies a market P/E of 22.2x. We then attach the 20% to reflect the historic discount relative to the US. We could of course say that the European market requires a higher equity risk premium than the US of say 4.5% rather than taking the 20% discount, but you get the same 18x multiple.↩
4. The European market has typically traded at an average 20% valuation discount to the US.↩
5. Operational gearing is the effect of fixed costs on the relationship between sales and operating profit. High gearing makes a firm’s profits more sensitive to a change in sales.↩