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). Furthermore, the ECB’s governing council declared that the eurozone has now moved into “expansionary territory”. 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 in.
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 terms. Indeed, our assertion about the Strategy’s performance still holds true, as it did in February 2017: