The case for Europe: is there value in uncertainty?

27/10/2017

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​Are Brexit fears affecting European markets?

A lot of uncertainty remains around the long-term consequences of the UK’s decision to leave the European Union, following the UK referendum on 23 June 2016.  Economists have struggled to agree how large the impact might really be, although consensus estimates for UK growth since the vote have been less damning than many expected. The UK has been helped by record-low interest rates, which make it easier to borrow money, and encourages spending and investment, although the Bank of England (BoE) will need to consider the long-term impact of such accommodative policies.

The purchasing managers indices (PMI) are economic indicators used to assess the health of the manufacturing sector, reflecting changes in spending plans in companies, inventories, orders and employment levels. Overall, they provide a useful measure of current business conditions and, more broadly, progress in the economy. The Markit Manufacturing PMI for Eurozone-based manufacturers was 57.4 in June and August 2017 – a six-year high – as shown in chart 1. 

Chart 1: Eurozone businesses remain optimistic



Source: European manufacturing PMI data, Bloomberg, as at 28 September 2017. Includes estimates for September 2017. Any number above 50 indicates the expectation of growth in the wider economy.

This suggests that we are in the best economic environment in Europe for years, although these estimates do not take into account the impact of Brexit negotiations. Discussions between Michel Barnier (the EU’s chief negotiator) and David Davis for the UK are at a crucial stage. A poor outcome for the negotiations could negatively impact both sides, although investors, thus far, remain calm.

Market volatility remains muted – but view with caution

Market volatility (the up and down movement of a particular stock market) is a reflection of investors’ sentiment and overall economic confidence. A ‘high volatility’ market, normally seen during periods of uncertainty about the economy, is likely to see dramatic fluctuations in values, whereas a low volatility market will see changes in value at a steady, predictable pace.

Chart 2: European markets have been relatively stable



Source: Bloomberg, EuroStoxx 50 Volatility Index (VSTOXX), as at 13 October 2017.

For European equity markets, the EuroStoxx 50 Volatility Index (VSTOXX) is a commonly used measure of market uncertainty. Volatility in European equities remains below its long-term average, and far below where it was during the global financial crisis and subsequent European sovereign debt crisis. This, in part, reflects strong corporate results in Europe, but there are risks that investors should keep in mind.

Investors have grown tolerant to the potential risks of higher debt in an environment of perpetually low interest rates. This might be a problem when bond yields start to rise, a likely consequence if interest rates in the UK and Europe move up from their current levels, or the European Central Bank begins to taper its monthly bond purchase programme (as part of 'quantitative easing'). This could lead to higher volatility in markets, as investors consider the potential consequences for those companies that have gorged on cheap borrowing, and face higher costs in repaying those debts.

For investors adopting a long-term strategy for their portfolio, market uncertainty is not something to be feared, providing an opportunity to invest in good companies at potentially attractive prices. For the time being, however, a period of lower market volatility should enable investors to concentrate on improving company fundamentals. It has been a long time coming, but we are finally starting to see a steady flow of positive earnings coming through in Europe, with many companies meeting or exceeding expectations for their profits.

 

Glossary

Global financial crisis (GFC):A series of financial market failures and bank crashes that led to a deep global recession. It began in 2007, when signs first appeared of deep problems in the US ‘sub-prime’ mortgage market, a market for mortgages provided to borrowers with poor credit histories. 

European sovereign debt crisis: This began in 2009, when fears around excessive government borrowing, initially focused on Greece, spread to include other Eurozone member states, including Portugal, Ireland, Italy and Spain. With interest rates on their debts rising, reflecting fear that they may not be able to repay debts, the European Central Bank was forced to intervene.

Bond yields (moving out): Bond yields are the level of interest (coupon) offered on a loan (bond), expressed as a percentage of the price of the bond. Bonds are traded in the market, which affects their price over time. If a bond is in demand, then its price will go up. As the coupon on the bond will not change, the yield will consequently fall. Conversely, the yield will rise if a bond falls in value. Higher interest rates may make the coupon bonds pay less attractive, resulting in lower bond prices, and therefore higher bond yields.

Quantitative easing (QE): A measure whereby a central bank creates large sums of money to purchase government bonds or other securities, in order to stimulate the economy.

Company fundamentals: The basic economics of a business, such as income, debt, cash flow and overall quality of management. These factors determine the health of a company, as well as an indication of its future prospects.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

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