The start of 2017 has marked an interesting turning point for value-conscious investors – particularly those focused on Europe. The sector rotation that was evident throughout much of 2016 picked up in the last few months of the year, with banks – for a long time the prime example of value destruction – leading the way and healthcare lagging. This was accentuated by the discussion around whether or not the European Central Bank (ECB) would start to taper its quantitative easing (QE) programme, in response to signs of a build-up of inflationary pressures.
But what does this mean for investors? On a longer term view, this could mark the start of a change in market leadership – one which is overdue and to be welcomed – from a ‘growth’ driven market to that of ‘value’. We have, for a long time, operated in an environment where investors have favoured quality European stocks ‘at any cost’ over the alternatives. 2016, however, saw a change in that mood music. The reasons for this are multiple, but broadly hinge on three factors: a) the rise of populism, which has put pressure on incumbent politicians to relax austerity, b) the prospects for long-term fiscal stimulus, and c) structural weakness in bond markets caused by excessive ownership, coupled with the potential for rising interest rates and inflation.
Politics – a risk and an opportunity
The most visible of the three primary factors is politics. Investors are always moving between greed and fear at the individual stock level, particularly during periods of uncertainty. A number of elections are due to take place in Europe during 2017, against a background of populist unrest, including the Netherlands (March), France (April and May) and Germany (September). Given the examples set by the UK’s European Union referendum result and Trump’s ‘against the odds’ victory in the US, the expectation is that any vote will probably give rise to increased volatility, even if this proves short-lived. Brexit also remains a factor to consider. We expect the UK to suffer versus the eurozone in a post-Brexit world, with a transfer of high margin and knowledge-based jobs across the English Channel, although this is probably more of a long-term trend.
Is global attention turning once again to Europe?
Europe, and specifically the Euroland (those countries that have adopted the euro as their primary currency), could be the interesting contrarian investment opportunity of 2017. Looking at the Shiller price/earnings (P/E) ratio, a useful measure of value that accounts for variations in corporate earnings over a 10-year period, the region is very interesting, relative to other major markets and particularly the US, as Chart 1 shows:
Chart 1: Still plenty of untapped value
|Current Shiller P/E||Long-term Median P/E||Discount (%)|
|US ||26.2||23.0||14% premium|
Source: JP Morgan, as at 31 December 2016. Shiller P/E (price/earnings) ratio is a cyclically adjusted valuation measure that assesses the price of a stock relative to average earnings over a 10-year period.
It is possible to argue that US equities deserve to have a higher rating than their European counterparts, because they offer a much higher return on investors’ capital. While true, some of this is artificially boosted through the use of debt to retire equity. If interest rates start to rise, however, this is likely to reverse. This would be negative for US companies when the growth in debt has been outstripping the rate of growth in earnings. In terms of earnings, Europe remains well behind the US, as Chart 2 shows, but in an increasingly value-focused market, investors are asking themselves whether the region has good potential to catch up.
Chart 2: The elastic has stretched very far
Source: Thomson Reuters Datastream, as at 31 January 2016.
In Europe, we expect to see economic recovery coupled with stimulative government measures and, as a consequence, bond yields may move out – a process that has already started. This could be the momentum that Europe needs. Regions such as Japan and Europe – traditionally more value-heavy markets – tend to do well during periods of global reflation. Should this continue, then Europe may once again have its day in the sun. Entry price is key and a process driven by bottom-up stock selection may help investors to identify those companies with overlooked or undervalued potential.