2017 has been very good for European investors thus far, with equity markets racking up double-digit percentage gains. With political risks receding and mounting evidence that the long-awaited earnings recovery is finally under way, are European stock markets poised to build on their recent gains after years of underperformance?
Investors appear to think so. Weekly inflows into European equity funds hit their highest level in 16 months in the aftermath of the French presidential election first-round vote, when it became clear that National Front leader Marine Le Pen was not about to deliver another populist shock to the global political system. Money managers appeared gung-ho for European equities even prior to the extinguishing of Le Pen's hopes, however. Merrill Lynch's April fund manager survey showed that the percentage of institutional investors overweighting eurozone stocks had hit 15-month highs. Enthusiasm toward Europe was spiking at the same time that US sentiment was deteriorating; fund managers' rotation out of US stocks and into Europe in April was the fifth largest since 1999.
In Germany, the Dax has hit multiple all-time highs over the last month; France’s Cac-30 is at its highest levels since 2008; the Euro Stoxx 50 has yet to take out its 2015 high but it too has outperformed the US this year, posting double-digit percentage gains.
It all marks a sharp contrast with 2016, when European equity funds suffered $113bn in outflows. Much of that money made its way to the US but that situation is now reversing – American equity funds experienced $22.2bn in outflows in the six weeks prior to Emmanuel Macron's election win in France, the largest redemption in more than a year.
This partly reflects a changed political outlook. Last year's political upsets in the UK and US had led to a rising political risk premium in Europe, but those fears have been eased by victories for centrist politicians in the Netherlands and France.
As a result, investors now feel more free to focus on the improvement in Europe’s economic fundamentals. Economic confidence in the eurozone recently jumped to its highest level in almost 10 years while Citigroup’s economic surprise index shows that data has consistently surprised to the upside in 2017.
Earnings taking off
Importantly, corporate earnings, largely stagnant over the last seven years, appear to be taking off. According to Barclays, the median company reported a 12.5 per cent increase in first-quarter profits and is beating sales and earnings estimates at a rate unseen in five years. The number of companies participating in the profits recovery is similarly impressive; the percentage beating estimates is also the highest in five years. Analysts are taking note. Roughly 70 per cent of companies have seen upgrades in their 2017 earnings estimates after announcing results; again, this is the highest level in five years.
The ratio of companies beating sales and earnings expectations versus those missing estimates is at all-time highs, cyclical stocks are outperforming defensives, and MSCI Europe index earnings are expected to increase by 15 per cent this year – all evidence, says Barclays, that an earnings "inflection" point has arrived. Morgan Stanley is similarly upbeat in its assessment of European earnings season, noting that almost half of companies have beaten estimates by 5 per cent or more.
US earnings are also rising, although not at the rate seen in Europe, and not enough to quell increasingly widespread fears regarding American valuations. The US stock market has trounced its international counterparts over the last eight years – so much so, according to Merrill Lynch data, that it began 2017 trading at a 40-year high relative to Europe. Now, investors feel it may be Europe's turn to take the baton. Merrill aforementioned fund manager survey showed that more than four in five investors – 83 per cent, a record high – believe US stocks to be expensive. Hence the desire to overweight Europe, where stocks are perceived to be trading at more reasonable levels.
Caveats
There are some important caveats, however. While it’s true that Europe is cheaper than the US, that is the norm – for a variety of reasons, the American market has almost always traded at a premium to Europe. Secondly, the differential between US and European companies is not as extreme as it appears. Sector differences – the high-margin technology sector is much more dominant in the US than it is in Europe, where financial and oil stocks tend to be bigger drivers of indices – account for much of the differential. If one excludes the financial and oil sectors, then the discount for European stocks is actually slightly smaller than historic norms.
Bullish sentiment means that Europe may also be vulnerable to a short-term reversal. Fund manager surveys are generally best viewed in a contrarian light; when a trade becomes crowded, any unexpected news can leave exposed investors scrambling for cover. Merrill Lynch agrees “on the allure of Europe’s earnings recovery” but there may be a little too much love for Europe, where “complacency looks extremely high”.
To sceptics, the current situation may carry echoes of early 2015, when investors bet big on a sustainable European earnings turnaround. European stocks stormed ahead in the first quarter but investors had gotten ahead of themselves. Even as a stock market correction set in, fund managers surveys showed investors continued to wrongly overweight European stocks and underweight the US throughout 2015. Excessively bullish sentiment is a headwind, bearish sentiment a tailwind, and this was an important factor in the US outperformance over that period.
Early innings?
Still, while frothy sentiment may mean European indices are at a heightened risk of short-term underperformance, Europe's bulls will be hoping a sustained period of equity market leadership is under way. In dollar terms, US indices beat European stocks by more than 100 per cent since the global financial crisis. That's a long spell of underperformance, commented MKM Partners technical analyst Jonathan Krinsky in a recent note. Accordingly, the recent rotation out of the US and into Europe and other international markets is likely "in the very early innings".
US stocks, said Krinsky, will likely continue to rise if global markets continue their breakout, but at a slower pace. At least 25 national stock markets have risen by at least 10 per cent thus far in 2017, “with many emerging from multi-year bases and downtrends”, indicating we may be witnessing the early stages of a multi-year shift.
Many of those 25 stock markets are in Europe. European investors have looked on enviously at the returns enjoyed by their US counterparts over the last eight years. Now, they hope, it may finally be Europe’s turn to lead.
