European stockmarkets have been attracting renewed investor interest as the debt crisis moves towards resolution. The recovery across ‘core Europe’ last year created a clear bifurcation between the solid – exciting even – growth of core countries such as Germany and the Nordics, and the problems of the peripherals such as Ireland, Greece and Portugal.
“Europe has been a continent of two halves, with the North performing much more strongly than the South,” says Simon Miles, head of Merrill Lynch Portfolio Managers, EMEA.
“We still think that large cap northern European stocks are attractive, particularly over the short to medium-term. Corporations around the world are building up large cash balances, some of which will end up in capital expenditure – and this will benefit the big European industrials and IT companies.”
However, Europe still has an image problem, a hangover from its socialist roots, which has been exacerbated in the last few years by the euro debt and Greek crises. Investors are by and large underweight the region, but that is beginning to change. European equity funds have seen steady inflows in 2011 as sentiment on the euro improves and governments make progress on their debt problems.
The optimism is largely driven by the North’s strong earnings growth; around 15 per cent earnings growth per share is expected this year, as revenues and margins strengthen. “We are seeing a different growth pattern in Europe than we have had for many years,” says Tim Stevenson, director of pan European equities at Henderson. “Growth has been slow in Europe but we expect a square-root-shaped recovery, before it then levels off.”
European equity markets are on low valuations, and offer handsome dividend yields. The average European stock is on a PE of 11 X 2011 earnings, which is at the low end of the historical range and cheap compared for example with Japan on 14 and the US on 13.5. The potential upside in valuations could therefore be underestimated, argues Nigel Bolton, head of BlackRock’s European equities team.
One attraction is that European companies have been forced to trim the fat over the last few years, and many are now lean businesses with strong cashflows and healthy balance sheets. These growing cash piles could be put to good use raising dividends, buying back shares and in making acquisitions.
Cesar Perez, chief investment strategist at JP Morgan Private Bank, points out that only 1 per cent of market cap is currently involved in potential M&A activity, and there is huge potential for that to grow, and for deals between businesses in the developed and emerging worlds.
“These markets have not been the place for growth stocks for years, and therefore the differential between stock multiples is at its lowest level because investors have previously not wanted to pay a premium for growth. Looking ahead, we think this will change and companies that are cash-rich and don’t have much growth potential will pay a high multiple for growth.”
Some of the cash will also be channelled back into Capex and this could be underestimated, adds Mr Bolton, who thinks investors have underestimated demand for replacement, particularly in sectors such as transport and travel.
Consumers are enjoying their share of this prosperity, and fund managers therefore favour luxury goods and other discretionary spending sectors such as cars. “Rising real asset prices are creating a wealth effect in the core economies, which is very good for the consumer,” says Alexander Scurlock, manager of Fidelity’s European Growth fund. “We think these structural trends could endure for three to five years.”
Germany out in front
Leading the way is Germany, where last year gross domestic product jumped 3.6 per cent, the most since unification, according to the Federal Statistics Office, and unemployment fell to levels not seen in 18 years. German plant and machinery orders are up over 40 per cent year on year, according to the VDMA machine makers’ association.
The German economy depends heavily on demand from emerging markets, as exports account for more than one-third of national output. The weaker euro has contributed to the North’s export success.
However, history may judge the first quarter of 2011 as an inflection point because while strong growth in the core is forecast to continue for the rest of this year, further out there is concern about the sustainability of the growth in emerging economies, and any slowdown in global demand will hurt European exporters. A minority of fund managers are therefore switching away from export-reliant sectors.
Another issue now becoming visible is the impact of higher commodity prices. “A number of sectors/stocks are exposed to higher input prices, such as soft commodities for food manufacturers or higher raw material costs affecting a variety of sectors, such as industrial goods, autos and chemicals,” says Alexandra Annecke, fund manager at Union Investment. “While there may be some pass through to customers, this depends on individual pricing power and will come with a lag pressuring margins in the meantime. This is not fully captured by analyst forecasts or market expectations.”
