In spite of negative headlines dominating, the European equity markets have been rising steadily over the last few years. Consequently investors are wary of adding to their European investments. In my last column, we looked at the macro fundamentals in Europe, which are on an improving path in light of the indicators such as PMI. Current PMI readings in Europe at about 55 is estimated to translate into a 3% GDP growth compared to the PMI readings of 52-53 which translated into a GDP growth of around 2% in 2015 and 2016. These macro fundamentals in Europe have not yet translated into corporate earnings in Europe, while earnings in the US have caught up with the improved macro fundamentals.
In today’s column we look at the reasons why we believe that European markets are likely to continue its upward trend over the medium term.
First we look at the composition of the European equity market. The following chart shows the sector weights and average dividend yield of the S&P 500 and S&P Euro 350 indexes.
In US, more than 23% of the index is composed of Information Technology (IT) stocks, while in Europe IT is only about 4%. IT stocks tend to be more growth and less defensive stocks and can be uncorrelated to economic trends. During late 2015 and 2016, we have seen the growth and less defensive stocks outperform compared to value and yield stocks, which characterise the European Equity Market.
In Europe, Financial stocks are around 20% of the index compared to less than 14% in US. Prior to the Global Financial Crisis (GFC), Financial stocks used to offer value and high dividend yield. However, since then, because of higher capital requirement, shareholders’ return has decreased. Financial stocks are sensitive to interest rate movements. They perform better in an environment when the market expects interest rates to increase. In Europe, yield of government bonds has started to rise in 2017 and the banks have improved their capital position. This should help the banks increase their margins and shareholders’ return in the medium term.
Also, Europe has a higher proportion of Telecoms and Consumer Staples, which are considered as defensive and relatively higher yielding sectors. Overall, in Europe, Value sectors have higher weightage compared to US. Earnings in these sectors lag any change in economic conditions. Therefore as the economic conditions improve, these sectors should show improved earnings.
Among the value and yield sectors, though the Utilities sector has about similar weightage in US and Europe, however, European utilities companies are more regulated and therefore shareholders’ return is part of the pricing approved by the regulators. This makes Utilities sector less volatile in Europe and supports the performance. They also tend to offer higher dividend yield.
The average dividend yield in Europe is about 3.38% compared to 1.97% in the US. Portfolios which invest in companies where dividend yield is supported by cash flow should outperform in the medium term.
Secondly, let us look at the basic valuation metric, which is the Price Earnings Ratio (PER). From the graph below, we can see that since 2012 the PER of the European markets has been relatively higher than that of the US markets. This is mainly due to the US markets have gone up by nearly 84% while the European markets have gone up by about 51%. In 2017 we are seeing the PER starting to narrow even as the market rises mainly driven by improved earnings by European corporates.
PER can be used to estimate the number of years the market expects the earnings to double. Prior to 2012, US corporate earnings were expected to grow at a faster pace than that of Europe. Since 2012, we have seen the US economy grow at a faster pace than Europe and corporate earnings improved. This led to the US markets rising faster over the period. The PER of around 25 in Europe is the market estimate for earnings to double in 4 years. At the current PER level, the market estimates that the earnings of European companies will double in about 4 years, while in US it will take longer than 5 years. Therefore, the higher PER in Europe indicates that the European companies will grow their earnings at a faster pace over the next 3 to 4 years. Therefore, we expect as the corporate results improve the markets will have the strength to keep its upward trend in the medium term.
In conclusion we believe that should see the overall improvement in earnings over this medium term cycle when we consider the expected economic growth and the composition of the market. The market also indicates that we should see faster improvement in corporate earnings from the view of PER.
Based on these factors, barring any unforeseen events, we believe that European equity markets are still cheap on a medium term outlook and we should see further rise of the equity markets over the next 2 to 3 years. Therefore, for now we would remain overweight Europe till we see any deterioration in fundamentals and if the earnings growth does not meet expectations. Again, based on the composition of the European market, investors should look at investing in funds which focus on quality stocks in the value and yield sectors.
By Kaustubh Misra, CIO, Samsung Asset Management London
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