In this article we discuss whether Europe’s economic momentum can continue and how will tighter monetary policy affect markets.
Supportive Economic Backdrop
Economic growth has improved and forward looking indicators remain positive. The economic expansion we’re seeing in Europe can continue. The key reason why, is that corporate management teams are now incentivised to invest and this is the leg of the recovery that has been missing. Capital expenditure can help prolong the current expansion.
More investment is certainly good for revenues but there is the prospect that costs will go up and this could squeeze profit margins. There is always an initial benefit from higher inflation, but as rates rise to contain this then that can trigger the next downturn. That is how cycles work.
Another aspect to consider is the structural reforms that have taken place in Europe over the past few years. Talking to companies, there are many in Spain for example who are very positive about the reforms that have been made. Europe is a big net exporter, largely due to Germany. But the internal consumption element is something that hasn’t yet come through and this could be the next element driving economic growth.”
The sovereign debt crisis in Europe is dormant but not over. Bond spreads have been suppressed by the authorities, via monetary policy, and will snap back at some point. In many ways, this better economic environment has made the challenge for the authorities more difficult.
Are European equities expensive?
Valuations have improved; we are ten years into an equity bull run. But Europe is about four years behind the US cycle . Cyclically adjusted price to earnings ratios are still below their long term trend in Europe so there is a gap to close.
Eurozone equities still look attractive, or even cheap, compared to other regions. Corporate profit margins in Europe are still some 30% below their 2006 peak so there is still room for improvement.
Relative to very expensive government bonds, equity valuations look reasonable. But one issue is that government bonds are finally starting to reprice. If this continues it could make equity market valuations look a little more stretched. In many ways though, one could view this as a good thing as it means the cycle is intact and we are not entering a Japan style slump.
There are three key considerations we would have for the coming year: 1) don’t get too greedy; 2) be diversified; and c) plan for a more difficult environment in the next two or three years.
Valuations in aggregate look fine. However, after years of zero interest rate policy and quantitative easing, dispersion between stocks and sectors is enormous as some have benefited from ultra low rates and some have not. Low or zero interest rates have allowed certain companies to grow and gain market share while making very low – or no – profits. That is a hugely deflationary force.
However, as investors, higher inflation means that we may start to require, for example, a 5% dividend yield to compensate for taking equity market risk. Companies that currently make little profit may find they need to raise their prices in order to pay that dividend. That could imperil their ability to grow, and call their current high valuations into question.
How will QE withdrawal affect European markets?
We’re not expecting the European Central Bank (ECB) to make a very aggressive change to policy; we think they will move quite slowly. Keeping control of the BTP (Italian government bond) spread is essential for ECB chairman Mario Draghi.
A return to positive rates will hurt growth stocks. This is what we mean by ‘don’t get greedy’. Those stocks have done well, but now is not the time to chase that performance.
In our view, German Bunds have exercised something of a gravitational pull on other bonds,especially US yields. Removing the anchor from Bunds could reset rates globally.
Is there a risk of currency wars?
Fears of US protectionism have so far been unfounded but the relative weakness of the US dollar has raised some concerns over the outlook for European exporters, particularly if growth elsewhere in the world were to slow.
We have had years of low growth where whoever had the weakest currency stole the biggest share of the pie. With the synchronised global recovery, that’s not the case anymore. We see no reason why the ECB should try to talk down the strength of the euro. Currencies generally are being allowed to move with fundamentals. Rates are a big issue but currencies are not.
On the demand side, there is the prospect that internal consumption could pick up the slack from any slowdown elsewhere. The rest of the world has long been asking Germany to consume more
Part of this comes down to Germany’s strong competitiveness. On average, Europe makes productivity gains of around 3% per year. In France, for example, this tends to be swallowed up by wage increases. That hasn’t been the case in Germany. However, German employers are now facing greater wage pressures; for example, the IG Metall union asked for a 6% increase and a 28 hour week. Germany needs to harvest its productivity gains and ensure these ‘trickle down’ to workers.”
Authors: Johanna Kyrklund, Global Head of Multi Asset Investment, Martin Skanberg, Fund Manager, European Equities, James Sym, Fund Manager, European Equities.and Grace Canavan, Head of Intermediary Business Development, Ireland. Website www.Schroders.com and contact number +353 (0) 85 254 9839.
Important information: The views and opinions contained herein are those of the authors and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, nor to provide advice of any kind. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Issued by Schroder Unit Trusts Limited, 31 Gresham Street, London, EC2V 7QA. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority. UK12325
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