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European equities revisited: The outlook remains bright

A year ago, amid widespread scepticism, we argued for a renaissance in Europe. In 2017, the eurozone recorded its fastest rate of economic growth in a decade, confidence soared and stocks rallied. Today, we revisit the case for European equities and ask: is the future still bright for the region?

Europe entered 2017 against a backdrop of political uncertainty. Many investors feared anti-establishment electoral threats as the region braced for a slew of high-stake elections in the UK, Germany, the Netherlands and France.

At the same time, we argued in favour of European equities in our commentary, Why European equities?”. The central premise was that the market provided attractive opportunities given that negative sentiment overshadowed the region. We also highlighted that companies are not the economy or the politics of any nation.

As we stated in February 2017:

“Weak sentiment provides great opportunities for stock pickers such as ourselves. As the market focuses on the enduring economic and political problems in Europe, opportunities for other investors to identify resourceful, innovative and growing companies will persist.”

Indeed, investors’ overt focus on political and economic uncertainty in Europe overlooked the solid progress of corporates, and created a clear valuation anomaly. Following a robust year in Europe, we believe it is an appropriate time to revisit some of the key points we made a year ago:

1. Economic growth: Today, it is hard to overstate the strength of the European economy as macroeconomic data continues to surprise to the upside. Confidence in the euro area touched a decade high last year, manufacturing PMIs are strong and GDP growth is robust at above 2%. The European Central Bank (ECB) upgraded its growth forecasts for the region in December, predicting growth of 2.3% in the year ahead (up from 1.8% in September) and 1.9% in 2019 (up from 1.7% in September)1. Furthermore, the ECB’s governing council declared that the eurozone has now moved into “expansionary territory”2. Meanwhile, data from the European Commission showed that the Economic Sentiment Index hit 116 in December, marking a 17-year high.

Economic growth is expected to remain strong. Despite eurozone unemployment dropping by 1.1 percentage points over the last year, it still remains at 8.7%, providing considerable slack before inflationary pressures kick in3.

2. Improved confidence: Encouraging macroeconomic data has sparked a renewed confidence among corporates. The successful IPO of Allied Irish Bank (AIB) in June last year is one such example. A bank in a European periphery nation, bailed out by the Irish government during the global financial crisis, AIB is now re-listed and trading at a premium to book value.

Furthermore, corporates are undoubtedly more constructive on the outlook, particularly in cyclical sectors. Synchronised global growth is supporting demand, inflation remains subdued, funding conditions are easy, all of which is providing corporates with the confidence to invest. This flows through to earnings, where in 2017 European companies broke the decade-long downgrade trend to generate growth of approximately 13%. Despite the stronger euro (the one headwind against our original thesis), we still anticipate 9-10% earnings growth in 2018, broad-based across both industries and countries.

3. Political risks continue to be overblown: The most acute challenges to Europe’s established political order failed to deter economic and earnings momentum in the region last year.  The outcome of the French election was most feared by investors. Emmanuel Macron demolished the old two-party system in France, but his victory in the presidential race was nevertheless a clear best-case result. In the context of stagnant growth, his appetite for reform is encouraging. Furthermore, the political shocks of 2016 – the vote for Brexit and the election of Donald Trump as US President – have not had the deleterious effects that almost all predicted.

The looming Italian election in March will dominate headlines and intransigence is likely to be the over-riding theme as Brexit negotiations continue. However, investors are starting to recognise that political events are not structurally impacting the health of the economy or the markets.

4. Central bank policy: In our 2017 commentary, we noted that many European companies have benefited from central bank policy. In October, the ECB extended its quantitative easing (QE) programme until at least September this year. However, minor rate rises are not expected by the ECB until mid-2019. As such, the ‘Goldilocks’ conditions remain.

5. Attractive valuations: Sentiment towards Europe may have started to improve, but crucially, valuations remain reasonable at an estimated 15.5x P/E and 3.3% dividend yield for 2018. We believe Europe remains at an earlier stage of the cycle, with latent earnings momentum.

The Hermes approach
Since its inception in 2007, Hermes European Alpha has achieved a net annualised return of 4.5% in euro terms4. Indeed, our assertion about the Strategy’s performance still holds true, as it did in February 2017:

“Such gains would not have been possible if we saw politics and the economy as equally important as the market.”

Figure 1: Net performance of Hermes European Alpha, since inception

Figure 1 Net Performance Of Hermes European Alpha - Hermes

Rolling Performance (%)

   30/11/16 to
 30/11/15 to
 30/11/14 to
 30/11/13 to
 30/11/12 to
 Strategy  11.39  -8.72  20.23  3.77  19.75

Source: Hermes as at 30 November 2017. Performance shown is the Hermes European Alpha Strategy in EUR, net of all costs since its inception on 18 June 2007.  Since inception, net performance was based on the management fee schedule of  75bps per annum on the first USD 75m and 50bps per annum thereafter. As of 1 January 2014, the management fee schedule was 75bps per annum. The benchmark is the FTSE All World Europe Index.  

The outlook is still bright

Although challenges remain in Europe, the turnaround is striking. At Hermes, we believe the economic improvement has plenty of room to run. As long as investors continue to quibble over European elections or macroeconomic data, we see opportunity. After all, everybody knows that it is prudent to sell amid euphoria. And that is a long way off in Europe.

  1. 1“ECB makes ‘significant’ upgrade to economic growth forecast,” published by the Financial Times as at December 2017.
  2. 2“New gear: Eurozone has moved into ‘expansionary territory’ says ECB”, published by the Financial Times as at January 2018
  3. 3“Eurozone jobless rate falls to lowest since 2009,” published by the Financial Times as at January 2018
  4. 4Hermes as at 05 January 2018. The stated return is net, annualised and in euro terms from the Strategy's inception on 18 June 2007 ending 30 November 2017.

The value of investments and income from them may go down as well as up, and you may not get back the original amount invested.

When considering an investment you should ensure that you read the offering documents before investing which will include a comprehensive list of the risks associated with the product. It should be noted that any investments overseas may be affected by currency exchange rates.

The performance of the strategy may have some dependence on the economic environment of emerging markets which may negatively affect the value.

Past performance is not a reliable indicator of future results and targets are not guaranteed.

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