Outlook 2018: European equities

We continue to see good prospects for pan-European equities in 2018, even after their recent gains. The MSCI Europe index is up 9.3% year-to-date and long-term European valuations are approaching their historic averages.

It is therefore hard to argue that the market is particularly cheap. However, we think strong returns can be achieved in 2018, driven by three factors: improving corporate profit margins, lower inflation, and falling correlations.

What is the outlook for corporate profit margins?

The European economy is a super-tanker – slow to change direction or pick up speed. But, after the global financial crisis and the sovereign debt crisis, the region’s economic recovery is now in full swing.

The better economic backdrop is helping to support demand. In turn, corporate profitability has been improving in Europe.

This is partly due to better pricing power (i.e. the ability of firms to raise prices without denting demand). It is also due to operational leverage as spare capacity in the economy is utilised, meaning companies can produce more while keeping costs stable.

Yet despite this recent improvement, corporate profit margins in Europe still lag behind those of their US counterparts. This stands in contrast to the experience of the 2000s when there was a large degree of commonality between profit margins in the two regions.

Closing this gap is likely to be a multi-year process. A continuation of the current profit margin expansion, within the stronger European growth environment, should provide opportunities for companies to exceed consensus earnings expectations.

A further positive piece of news for stockmarket investors is that the spectre of deflation has faded but inflation remains muted. This is due to several factors, including demographic changes and disruption from new technology. We think inflation is likely to stay low, albeit higher than the ultra-low levels of a couple of years ago.

Low inflation can be beneficial for equities

In a low inflation environment equities can provide a strong alternative to low yielding competing investments such as fixed income, which in turn offers scope for a lower equity risk premium. This is the return above the risk free rate (i.e. the rate offered by government bonds) that compensates stockmarket investors for taking on the relatively higher risk of equity investing.

In turn, a lower equity risk premium supports a higher overall market valuation than the historical norm.

This refers to the market as a whole, but clearly there are wide variations in the valuations of different sectors. We think another important factor that could support equities next year should be declining correlations between sectors.

Stockmarket correlations are falling

Correlation measures the degree to which stocks or sectors behave in the same way. Over the past few years, stockmarkets have primarily been driven by macroeconomic factors – such as quantitative easing – meaning that correlations have been high.

As a consequence, active managers have found that fundamental stock analysis was less impactful than it should have been in sorting winning stocks from losers.

This has already started to change and we think the trend of lower correlation – both between sectors and within sectors – should continue. Many companies’ share prices are still artificially boosted by macroeconomic factors; others are legitimately supported by strong fundamentals. As stock correlations fall, we believe the market will clearly show which is which.

This creates a more conducive environment for our investment approach, which is underpinned by stock-specific analysis. A world of lower correlations means superior returns should be achieved by selecting the right individual stocks, rather than focusing on broad macro themes.

Volatility provides opportunities

At the start of 2017, investors were worried about the political backdrop in Europe, and specifically the outcome of the French presidential election. The win for centrist Emmanuel Macron provided reassurance to markets and political worries faded.

Politics hasn’t gone away though, as evidenced by the Catalan independence referendum and collapse of coalition talks in Germany. Italy’s elections are due by May 2018 and the UK’s Brexit talks continue.

We would tend to see volatility around political events as a potential buying opportunity. Political risk can often be excessively discounted, meaning that stocks can fall to valuations that do not reflect their fundamentals. This can give active managers a chance to be opportunistic and buy stocks at very attractive valuations.

The eurozone’s economic recovery remains strong and the central bank is still providing support, albeit on a reduced basis. Moreover, political uncertainty often results in a declining euro, which is often good news for the region’s exporters.

Other articles in our Outlooks 2018 series are available here.