European equities tick a lot of the right boxes right now. Economies are recovering – indeed the first quarter of 2017 saw Europe once more grow faster than the US, having outpaced the world’s largest economy in 2016. Valuations are not excessive, either relative to the region’s history or the US equity market. Like almost anything, European equities also look compelling relative to bonds. The final part of the jigsaw puzzle might have been earnings growth, but here too Europe is, at last, getting close to achieving a gold star.
Exceptions rather than the norm
Most of this has been known for quite a few months now and is part of the explanation for the better performance of Europe year to date. Even the euro has strengthened against the US dollar, from about $1.05 at the start of 2017 to $1.12 at the time of writing, as Chart 1 shows. Politics looks more settled, after the surprises of the Brexit vote last year in the UK and the election of Donald Trump in the US. Perhaps a comment I made at the beginning of 2017, that “by the end of 2017 the UK and the US might look to have been the exceptions” when it comes to successful populist votes, seems more prescient.
Chart 1: Euro has strengthened vs the US dollar in recent months
Source: Thomson Reuters DataStream, as at 6 June 2017.
Now that the political backdrop is perhaps more settled, the UK’s potentially tragic Brexit decision aside, how long can a resurgence of interest in Europe last? One threat is the gradual move towards ‘tapering’ by the European Central Bank (ECB). But it is already clear that this will be a very slow process. The economic recovery in Europe remains quite slow and inflation, outside the UK, is well below the ECB’s target of ‘below or close to’ 2%. At the same time, the damaging effect of negative interest rates needs to be avoided.
What could derail this market?
Writing ahead of the general election result, the UK remains the one exception to what looks to be a relatively rosy scenario in Europe. The Brexit ball is rolling onwards, following the invocation of the now infamous Article 50, but the vote was another distraction. The UK is still no closer to knowing what sort of Brexit is desirable, or more likely, economically feasible. Once the reality of debt, demographics and a weak currency become clear, I suspect that the UK market will struggle further against other European peers.
Elsewhere in Europe, economies look well set, and I suspect that more capital spending and investment are likely to be incentivised with tax cuts in Europe, again outside the UK. In this scenario, those capital investment-related names such as Siemens, Legrand and Atlas Copco should continue to do well. Luxury names, and auto makers, many of which have rallied hard so far in 2017, are likely to struggle due to subdued consumer demand. Financials have also seen mixed performance so far, with insurance underperforming banks. This seems an anomaly given the paramount importance of long-term savings to cater for retirement.
It would be entirely healthy for European markets to drift through what will hopefully be a quiet summer, without shocks such as Brexit to contend with. All seems well set though for European markets to trade higher than current levels by the end of 2017.