Outlook for European equity markets

Political risk remains the main risk to the European economic outlook, and thus to markets

Year-to-date review: three factors that have set the tone for equity markets in 1H 2015
Coming into 2015, we believed that three key factors would set the direction of equity markets in the first half of 2015: The first was whether the ECB would launch a large enough QE programme. And indeed, since its start on 9 March, it has already shown the desired effect of putting further pressure on the euro. Additionally, we finally see loan data improving even in Italy and France. On that issue, we find the recent discussions with regards to the ECB ‘tapering’ its QE programme as way too premature, and believe the ECB is set to remain on course at least until September 2016. This will continue to keep a lid on the EUR/USD exchange rate and will provide further support for equity markets. The second issue was a Ukraine/Russia cease-fire and de-escalation of tensions in the region. The progress made in this regard is crucial, as we still believe it was the geopolitical tensions in Ukraine and the resulting sanctions against Russia that created the sudden stagnation in the European economy during the second and third quarter last year. Third, the Greek election outcome and the negotiations with the creditor insititutions. In this regard, we continue to be relaxed about downside risks from a potential Grexit, especially since 75% of outstanding Greek sovereign bonds are owned by ECB, IMF and EFSF funds, and any contagion effect from the current stand-off between Syriza and the Eurogroup to other peripheral bond markets should be minimal now that the ECB started its QE programme on 9 March. All of these positives helped European equity markets to rally strongly during the first quarter.

Bond markets pricing in crisis, while data shows recovery
The biggest debate in our mind now is the growing dichotomy between bond and equity markets in the developed world. 50% of developed market government bonds with a 2-to-5 year maturity are now trading at negative yields. Sovereign bond markets are priced as if we are heading into a systemic deflationary crisis similar to 2007/2008. To the contrary, incoming economic data continues to point to a nascent recovery in the eurozone. We believe the extremely low to negative yields in the US and Europe should be temporary and do not signal an impending global economic crisis. Investors coming to grips with this temporary mispricing in bond markets (also due to the ECB’s bond buying, which partially manipulates price-setting) will also start to apply lower risk premiums to equity markets, and this should set the next stage for the bull market in Europe. Within this macro framework, we continue to find the best risk/return trade-offs in cyclicals, which still only trade at average 2012–2014 recession-year levels versus defensives.

European earnings still far below US peers
Of course, following the sizeable gains in the first quarter, markets might take a bit of a breather in the near-term, but the mid-term outlook for European equities remains intact. Although the market has now re-rated to mid-cycle multiples, key to note is that earnings in Europe have yet to enjoy a recovery like that seen in the US. European EPS are still 30–35% below their 2008 peak, while US EPS are already 25% above their 2007 peak. However, one should not value assets at trough level conditions at mid-cycle multiples, and that is the essence of the case. As investors develop even more confidence that European companies can deliver real ROE and EPS growth recovery for next three years, there will be further upside to equity markets in 2015.
Political risk remains the main risk to the European economic outlook, and thus to markets. Political complacency has to be watched, as structural labour market reforms have to continue in Italy and France, while the integration of the eurozone’s institutions towards a tight banking and fiscal union needs to move forward. As Mr Draghi said recently: “We need to move from a system of rules and guidelines for national economic policy-making, to a system of further sovereignty sharing within common institutions.” The ECB’s current loose monetary policy is obviously buying time for the political leadership to make this possible by creating an improving cyclical economic backdrop.

Can Elbi – manager – JB Europe Focus Fund