The case for Europe

RYAN  By Guest Blogger Ryan Lewenza

In making “The Case for Europe” I’m not suggesting that readers should experience Paris’s spectacular Louvre museum, or stroll down Florence’s Ponte Vecchio bridge or indulge in “pintxos” in the beautiful seaside Spanish city of San Sebastien (but you should try to do all of these). Rather today’s blog is about the bullish case for European equities and why we believe investors should have some exposure to this region.

It’s been an uphill battle for the European economy in recent years as the region has had to contend with weak economic growth and low inflation, rolling crises from Greece’s near default, banking sector woes, and more recently Brexit, all the while having to grapple with a refugee crisis where an estimated one million refugees flooded into Europe in 2015 alone. It’s been a tough go, but we believe things are looking up.

Europe has seen a nice rebound in economic activity with GDP rising from 1% Y/Y in mid-2014 to 1.9% currently. The manufacturing sector is particularly robust these days with Europe’s PMI Manufacturing Index surging from 51 in early 2016 to 57 as of May. And inflation has started to perk up with headline inflation rising from a low of -0.2% Y/Y in 2016 to 1.4% in May. Europe is benefiting from stronger exports with the lower Euro, accommodative European Central Bank policies, stronger employment trends, improving confidence, and higher sentiment readings. We see this trend continuing in the coming months.

Europe’s Economy is Showing Positive Momentum

Source: Bloomberg, Turner Investments

Another big support for Europe has been the recent positive election outcomes in Netherlands and France. There, populist, anti-EU candidates like Marie Le Pen in France succumbed to more centrist, pro-EU candidates, which we believe is very positive as risks of an EU breakup have significantly diminished. Next up is the German election and we see the steady-hand, Chancellor Angela Merkel, winning her fourth term in September. Essentially, political risks in Europe have significantly diminished, which is captured in Europe’s Policy Uncertainty Index. This index tracks newspaper articles containing terms like “uncertainty” or “economy”, and you can see that it has dropped materially in recent weeks, following the French election. The US Policy Uncertainty Index, in contrast, continues to rise over growing concerns regarding President Trump and the political crisis that is engulfing his administration.

Diminishing Policy Uncertainty Risks in Europe

Source: Bloomberg, Turner Investments

Since the financial crisis low in March 2009, US equities have been the standout winner with total returns of roughly 280% versus European stocks up 160%. As a result, valuations for US stocks have risen significantly with the MSCI US Equity Index trading at 19x forward earnings versus MSCI Europe at 16x. Admittedly, European stocks have historically traded at a discount to US stocks, but this is a particularly wide gap and, given the improving fundamentals, we see this gap narrowing over the next year, resulting in European stocks outperforming US stocks.

European Equities Are Cheap Versus US

Source: Bloomberg, Turner Investments

Now we don’t just rely on fundamentals in determining our investment strategy and portfolio positioning. We incorporate technical analysis into our calls, often using major technical events as the trigger to make a change. Well we got a big “trigger” in recent weeks with European stocks finally breaking out relative to US stocks. So for the first time since 2014, European stocks are finally starting to do better than US stocks. This was an important event, and combined with the positive French election outcome, this has led us to become more constructive on the region.

European Equities Breakout Technically Versus US

Source: Stockcharts.com, Turner Investments

Europe is far from perfect as it still has a number of issues and headwinds to contend with. For example, while the banking sector is looking a lot better it is still riddled with some bad loans and lower capital ratios. Italy’s Banca Monte dei Paschi di Siena is a good example as it remains on life support. Many European nations also have high government debt levels which is a concern. And Europe continues to drag its feet on implementing much needed structural reforms such as labour reforms, making it easier to hire and fire staff, and reducing public sector spending which represents nearly 50% of the European economy.

While these risks remain, we believe there are more positives than negatives, and why we believe European equities are set to outperform over the next 12-18 months. So go pick a French baguette and an espresso, add another Porsche to the car collection, and if we’re right on our call for European equities to outperform, you should have no problem paying for these great European products.

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.