Eurozone is only in the beginning of an up-cycle

With the European economy in its strongest recovery since 2010 and European earnings expected to rise at a solid double-digit pace in 2017, the future for European equities looks bright. Europe is currently our preferred spot in global financial markets from an asset allocation perspective.

Looking at the bigger picture, we see a remarkably broad-spread and synchronized recovery in the global business cycle and in corporate earnings. Inflation and monetary policy normalization are progressing gradually as well. The corporate sector is also looking healthier. Prospects for increased capital expenditure are on the rise, and business spending could begin making an important contribution to global growth.
Earnings growth is poised to accelerate. The first-quarter reporting season was characterised by growth in sales and margins that enabled results to beat estimates convincingly. The financial and commodities sectors also benefitted from comparison effects. For 2017 earnings, the consensus is expecting growth of more than 20% in the Eurozone
While market indicators show few signs of investor exuberance, and sentiment and positioning data do not suggest excessive risk appetite, equities are showing some signs of being overbought and low market volatility levels are signalling short-term complacency.
The rally in equities towards multi-year highs – or even record highs, in the case of the US – raises the question of whether markets are currently overvalued. The answer depends on the reference period, the valuation of competing asset classes, and the phase in the business cycle. Based on absolute metrics like trailing and cyclically adjusted price/earnings (PE) and relative metrics like the risk premium, we think valuations are high but not stretched, and should not be used as an argument to become bearish. Valuation, moreover, is not a good timing instrument and plays a limited role in our tactical asset allocation decisions.
Since March 2009, trailing PE has climbed from 9 to 19, the highest level since 2004 and 13% above the 35-year average. However, there have been long periods during which the PE was higher and we are still within the normal range. Of course, regional differences are important, and the US has arguably entered the “danger zone”, having exceeded one positive standard deviation. One would have to look to the start of the internet bubble to find higher PEs in the US, but even then, the US market moved another 40% higher.
Another element to consider is the point in the earnings cycle. Although the US is further advanced than the Eurozone, US companies could report double-digit earnings growth this year and, depending on whether Trump can cut taxes, next year as well. The Eurozone is only in the beginning of an up-cycle and, if growth holds up, will also manage to realize double-digit growth over the next two years.

Valentijn van Nieuwenhuijzen – Head of Strategy and Multi-Asset – NN Investment Partners