Equities: What if everything improved in Europe tomorrow?

Global stock markets have been faltering for about a month now. Investors are fully aware of the risk factors: strained valuations, overbought markets and growing geopolitical concerns. Moreover, the populist wave has made the markets fragile over the past few days.  Unusually though, Europe is outperforming the US: European equities have gained 2% in the space of a month vs. a slightly negative performance for American stocks.

Clear advantages

Europe has long been unloved by global investors, who have often suffered from the region’s anaemic economic growth and governance problems. And yet, despite tangible jitters in the global markets, investors have not completely turned their backs on European equities. So what is happening? Europe benefits from several advantages:

1. European leading economic indicators show a noticeable improvement in the economy.

2. Earnings prospects of European companies have been revised upwards. In 2017, the markets are expecting earnings growth of 15% in Europe vs. 10% in the US. Thanks to the better economic climate, European companies will benefit from a rise in revenues, and in turn, strong operating leverage.

3. Monetary policy in the eurozone remains expansive for the time being.  Although the knock-on effects of the growth momentum on employment and prices are visible, they are not strong enough for the European Central Bank to envisage reducing its support.

4. Stock market valuations remain reasonable, in comparison with the US. European stocks are trading at a price-to-earnings ratio of 15x, much lower than their long-term average.

Clearly, investors will be able to fully measure the scope of these advantages as soon as political risks fade. If a greater political stability and a more coordinated European project are confirmed after the major elections in 2017, investors (particularly foreign) might be attracted to European equities once again.  Considering the current valuations, this could translate into a very positive effect.

In this scenario, which sectors are likely to outperform?

In the context of an economic recovery, two themes might (theoretically) find favour with investors: consumption and investment. Sectors that are strongly reliant on domestic demand in the eurozone (e.g. retail, media, leisure) have not benefited from the recent stock market rally.  Indirectly, the banking sector might also benefit from the better economic climate and higher real interest rates. On the other hand, the investment theme, via industrial stocks, has already benefitted from the change in rhetoric of the US administration (tax cuts and infrastructure plan), higher commodity prices and the weak euro. The sector is now trading at relatively high valuations.  

In conclusion, despite the forthcoming elections, Europe offers huge opportunities that investors could seize, albeit with certain selectivity.

Read more about the most vulnerable sectors of the Economy to Political Uncertainty