Europe Now

From advances by populist movements to withdrawal of monetary stimulus, investors in Europe are facing tough hurdles at every turn. But despite the challenges, Europe’s relative value has improved and selective investors can identify many opportunities in regional fixed income and equity markets.

Potential volatility and political risk are constant concerns. Market volatility in October served as a stark reminder that the investing environment is anything but simple. Yet today, with the right perspective on the risks, investors can overcome uncertainty, position for changing market conditions and capture promising sources of long-term return potential across the region.

Putting Political Stresses into Perspective

Europe’s political landscape often feels like a minefield for investors. Ever since the euro crisis threatened the single currency and the Brexit vote challenged the European Union, investors have felt that markets are hostage to political fortune. Some have simply stayed away.

But in fact, European equity markets have advanced through challenging times. It’s true that European stocks have lagged US markets in recent years, as US earnings have been powered by high-growth technology and new media stocks. Still, The MSCI Europe advanced by 6.7% annualized from 2010, when the Greek debt crisis erupted, through October 2018. And from July 2012, when ECB President Mario Draghi said he would do “whatever it takes” to save the euro, European stocks returned 8.2% a year. In fixed income, Euro high yield returned 6.3% annualized from oct 2010 to Oct 2018, and 6.9% since July 2012. These are solid returns considering the political headwinds weighing on regional markets, in our view.

So why have European markets continued to rise over the longer term? Monetary policy support explains much of their gains. Draghi’s vow to support the euro gave companies—and particularly banks—breathing space to get their balance sheets in order. Corporate leverage has fallen, banks are much better capitalized and many have significantly reduced their nonperforming loans (NPLs) (Display).

Of course, the stability of the banking sector remains a big concern. In particular, investors are worried about potential write-offs from investments in emerging markets and the impact of a disruptive Brexit. But we believe that the worst outcomes will not materialize; recent stress tests by the ECB indicate that banks have enough capital to absorb any impact without serious harm to investors.

Macroeconomic Environment: Softer, but Stabilizing

Beyond the political headlines, the macroeconomic environment is softening, but stabilizing. After allowing for possible fallout from China-US trade tensions, we still forecast GDP growth of around 1.5% for the euro area in 2019—roughly in line with the trend. Underlying inflation should remain subdued at about 1.4% (up from 1.0% in 2018). Although some forward-looking economic indicators have weakened, unemployment continues to fall and wages are rising, which should support consumption.

These economic conditions should allow the European Central Bank (ECB) to end its net asset purchases at the end of December as planned. The ECB has already started to taper its bond buying, having cut its €30 billion monthly purchases to €15 billion from 1 October. Given the risks to growth, more aggressive tightening from the ECB is unlikely and we expect eurozone interest rates to stay ultralow through to the end of 2019—which will continue to support markets.

Can European economies and markets overcome the end of the accommodative policies that have supported risk assets for several years? If European economies start to flag, we think the ECB has a wider range of levers to pull (Display) to keep momentum positive and to address possible problem areas, such as a spillover to the rest of the region from rising populist pressures in Italy. Increased volatility is likely as ECB buying eases. We see this as a short-term technical factor which could create buying opportunities for investors

Equity Valuations Are Attractive

For equity investors, stock valuations look attractive—especially versus US equity markets. European stocks are typically cheaper than US peers. But these days, the discount is bigger than usual. By the end of October, European stocks were 30% cheaper than US stocks based on price/trailing earnings ratio—a much deeper discount than the 19% average since 1990 (Display). Meanwhile, with US profitability touching record highs and European earnings and margins below recent peaks, we think there’s plenty of room for European companies and stocks to gain ground. And within Europe, the dividend yield of the MSCI Europe exceeded the 10-year European government-bond yield by 2.05% (at the beginning of October), compared with an average of 0.06% since 2001.

To be sure, Europe and the US are very different markets. The US is heavily weighted towards fast growing technology companies, which typically command a significant premium, while Europe is more exposed to banks. But even after adjusting for these sectoral differences, we think the discount of European equities is deeper than deserved.

What should investors look for? We think companies that benefit from the European discount but are exposed to global business trends are especially attractive. Focus on cash flows, which can provide a clearer outlook than accounting measures. And forecast the return potential over a multiyear horizon. These three ingredients can help investors find European candidates with promising return potential—no matter how the politics play out.

Bonds: Finding Opportunities in a Changing Market

Europe’s fixed-income markets also offer good value for active investors who can position for changing conditions. Until recently, bond yields in the US were significantly higher than in Europe, even after adjusting for the cost of hedging out currency risk. But now, the rising cost of hedging has started to tilt the balance of adjusted yields in favour of European bonds. In other words, the increased differential between US dollar and euro short-term interest rates has substantially raised the cost of hedging and wholly eliminated the US yield advantage for euro investors.

Beyond the currency trends, our research suggests that the European credit cycle is between 18 and 24 months behind the US. Net leverage is falling in both European high-yield and investment-grade sectors (whereas US corporates have re-leveraged), spreads have widened since the beginning of the year and new corporate issuance is lower than in recent years, with net supply only marginally positive. New issues in high yield are also being raised predominantly for normal refinancing, not for dividend distribution and riskier M&A activity. Default rates are still very low too, and are expected to remain low given solid growth and very low risks of steep interest-rate hikes from the ECB.

This environment puts European credit in a sweet spot, especially with government-bond yields still near record lows. European high yield, in particular, now offers better terms than US equivalents, with wider spreads and higher credit quality on average. European AT1s (subordinated financials) also present especially good value, in our view.

That said, selectivity is paramount. Some retailers are facing headwinds and some automakers will be affected by fallout from US-China trade wars. In Europe, within high yield, current valuations of issues rated CCC and lower don’t adequately discount their risks. Yet the banking sector still offers attractive yields supported by stronger balance sheets and improved asset quality.

Europe Now: The Time Is Right

Europe’s investing landscape is complicated, but there are compelling reasons to reassess regional markets today. Strategic investing approaches to equity and fixed-income markets can help create portfolios that transcend political risk and capture long-term return potential in changing market conditions.

Sources: Bloomberg Barclays, European Banking Authority, European Central Bank, Institute for Economic Research Germany, Morgan Stanley, MSCI, S&P and AllianceBernstein (AB)