The recent events in Greece remind us that Europe can still be a scary place for investors. Although the debt standoff with Greece ended fairly amicably, periodic market scares will likely re-emerge.
Even as the Greek drama was unfolding, market strategists implored investors to stay focused on the bigger picture. Because beyond that country’s borders, the economic clouds hovering over Europe are beginning to part. And that spells opportunity.
The Trillion Euro QE
Desperate times have indeed called for desperate measures. Faced with a prolonged economic stagnation across Europe, the European Central Bank finally began its own version of central bank bond buying earlier this year. And as if on cue, “green shoots” are starting to appear on the European landscape.
It’s too soon to declare victory, but Europe is clearly seeing the first stages of an economic upturn. In recent months, investors have taken note of a rebound in retail sales and purchasing manager sentiment, highlighting bullishness among consumers and businesses alike. Economists now expect that euro zone economies will collectively grow around 1.5% this year, and close to 2.0% in 2016.
That may not sound very impressive, until you realize that the euro zone has been flirting with recession ever since the financial crisis of 2008. The talk of a “lost decade” and a “lost generation” of unemployed youth has been replaced by hopes of a potentially virtuous economic cycle where strengthening demand begets yet more strength.
Europe now has clear tailwinds in place for a sustained upturn to take root. “The drop in oil prices, interest rates and the euro will all have an impact on the economy,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman and author of the marctomarket.com blog.
Those factors should increasingly come into play now that Europe has proved its ability to handle the crisis in Greece without any major fallout. “Greece has been ring-fenced,” says David Kotok, chief investment officer at Cumberland Advisors, adding, “It’s the Rhode Island of Europe, and in any event, a ‘Grexit’ wouldn’t have derailed the rest of Europe.”
With Europe charting a brighter course, a key question emerges: What kind of opportunities will emerge for investors seeking exposure to the rebound?
Draghi’s Foresight
While ECB president Mario Draghi is garnering praise for his support of vast bond-buying efforts, it was his 2011 push to clean up European banks that may have provided the real impetus for growth. A series of capital injections and much-needed stress tests have led to today’s more favorable lending environment in Europe.
“The European banks are in much better shape than they were a few years ago; they’re better regulated and stronger financially,” says Russ Koesterich, BlackRock’s global chief investment strategist. He adds, “The credit channels are beginning to thaw out for both consumers and businesses.”
Koesterich, along with other strategists, believes that European banks now hold great appeal for investors. Yet it’s hard to identify a suitable exchange-traded fund for this sector. The iShares MSCI Europe Financials ETF (EUFN), for example, has roughly 50% portfolio exposure to the U.K. and Switzerland, neither one of which is in the euro zone. Investors can go the single stock route with banks such as Deutsche Bank.
Although all member states are benefiting from a drop in the currency’s value, each nation has a unique set of opportunities and challenges. As a result, a country-specific focus may be the better path.
Of course, it’s hard to go wrong with Germany, which proved its mettle during the financial crisis and has emerged as the strongest economy in the beleaguered region. Indeed, the Credit Suisse Germany Index has risen roughly 90% in the past half-decade, nearly matching the gains of the S&P 500.
Yet U.S.-based investors haven’t done quite as well. The sharp drop in the euro has led to a huge impact on portfolio returns. For example, the iShares MSCI Germany fund (EWG) has fallen roughly 6% since the start of 2014, while the WisdomTree Germany Hedged Equity ETF (DXGE) has risen roughly 12.5% in that time.
That gap has led many investors to pose a simple question: to hedge or not to hedge? The answer is not quite as straightforward.
Currency markets are all about reversals. A drop in one currency tends to alter trade balances and foreign direct investment flows to the point where the stronger currency (in this case, the U.S. dollar) tends to see outflows and an eventual pullback.
This time around, that trend may not play out so neatly. While Europe is embarking on massive bond-buying and is expected to keep interest rates at ultra-low levels, the United States Federal Reserve has already completed its bond-buying program and is expected to soon start raising rates. As a result, the factors that have pushed the euro lower may stay in place for some time to come.
Cumberland’s Kotok thinks the currency shift has ample time to play out. He figures the euro, which is currently worth around $1.10, is headed to parity with the dollar in the near term, and perhaps to below 90 cents over the long haul.
“The euro has been below 85 cents before, and that level may represent the long-term clearing price,” Kotok says. That view is shared by economists at Goldman Sachs, who also think the dollar will materially strengthen against the euro in coming quarters.
A weaker currency should set the stage for export strength in Europe, which is a key theme for certain strategists. “Europe is a much bigger exporter—relative to their GDP—than the U.S., so they’re really depending on stronger world growth,” says BBH’s Chandler.
Buying Time
Economists note the ECB’s massive bond-buying program was primarily intended to buy time for European companies to enact badly needed structural reforms. The process is under way across the Continent, with mixed degrees of success. “Spain has certainly done the right reforms to comply with EU loan packages,” says James Hunt, a portfolio manager at Tocqueville Asset Management.
BlackRock’s Koesterich also thinks Spain is making tangible progress, which should help to unshackle the historically constrained economy. “You’re going to see a solid rebound in Spanish consumer demand,” he predicts.
Alessandro Valenti, a portfolio manager at Causeway Capital, is a big fan of Spain’s CaixaBank (CAIXY). It is the country’s largest bank focused on the domestic economy. (Rivals such as Banco Santander have vast operations outside of Spain as well.) “Management is working very hard to unlock value by exiting non-core real estate segments,” he says, adding that the moves should free up a lot of capital to return to shareholders in the form of dividends.
The Margin Gap
At first blush, European stocks aren’t a profound bargain relative to U.S. stocks. The S&P 500 is valued at around 16 times projected 2016 profits while the Stoxx Europe 600 is valued at roughly 15 times next year’s earnings. But on a price-to-book basis, a sharper disparity emerges.
Ron Saba, a senior managing director for Horizon Investments, notes that European stocks trade for only two times book while American stocks trade for three times book. “The U.S. continues to get more expensive while Europe has not,” he says.
There’s a simple explanation for that price-to-book gap: American firms are vastly more profitable, with 13% trailing operating margins, while their European peers generate 8.8% operating margins, according to Saba.
He cites U.K.-based Unilever PLC as an example of a comparatively undervalued European multinational. The consumer products giant has exceeded consensus analysts’ forecasts for two straight quarters, in part because of margin gains accruing from euro-related expense savings.
“Manufacturers with an asset base in Europe and a strong sales base in the U.S. are in a great position,” Saba says.
Tocqueville’s Hunt points to industries such as building materials, media, industrials and consumer discretionary stocks as industries that should hold appeal as the euro zone recovery takes root. “We like the current valuations in these sectors, and there’s ample room for profit margin improvement,” he says.
Kotok believes that the pharmaceutical, machine tool and technology sectors hold strong appeal right now. He is also focused on companies with a strong export focus. “A company like Siemens could be a classic beneficiary,” he says.
Joseph Calhoun, CEO of Alhambra Investment Partners, has been focusing on European telecom firms. “Companies such as Vodafone, Telefonica de Espana and Deutsche Telekom offer great yields,” he says, adding, “It’s a very stable sector in terms of revenues.”
A Vote For France
While countries such as Ireland and Spain (and to a lesser extent Italy) get credit for structural economic reforms, France has remained something of a punching bag for strategists, who note the country’s sclerotic bureaucracy and restrictive labor laws. Yet even France is starting to give off a brighter sheen, with recent economic reports suggesting an upturn has taken root.
Analysts at Goldman Sachs point to a “combination of cheaper oil prices, weaker exchange rate, lower interest rates and reduced fiscal drag” that is boosting French business confidence. They believe that the stage is set for a steady reduction in France’s stubbornly high unemployment rates, which could trigger a boost in consumer spending.
Indeed, the entire Continent is in dire need of robust job creation. “The real thing holding back domestic demand is the lack of job growth,” says BBH’s Chandler. The official euro zone unemployment rate stands at 11.1%, a three-year low, though that is still roughly twice the levels seen here in the U.S. Fully 18 million people in the currency zone remain out of work. Chandler believes that “cutting red tape, further labor reforms and other measures are the key to future employment gains.”
What Could Go Wrong?
One of the reasons the ECB is comfortable with plans to spend more than 1 trillion euros to reflate the economy is the utter lack of inflation (which currently stands at 0.2%). ECB president Draghi aims to stimulate the economy to the point where prices are expanding at a 2% annual pace, a clear sign that Europe’s “animal spirits” have returned.
But what if growth begins to wane, even as inflation starts to pick up? That could set off big alarm bells. We’ve never seen what happens when a central bank’s balance sheet greatly expands without any tangible impact. This “pushing on a string” scenario is the greatest risk that strategists see in pegging a European rebound. In a worst-case scenario, further economic weakness, coupled with Europe’s massive current debt loads, will lead bond vigilantes to pursue a ruinous spike in interest rates.
Yet for now, all signs point to early stage growth. Economists are closely monitoring the nascent upturn, and once it appears to be sustainable, European companies will have the economic environment to expand operating margins, which should lead to higher valuations for European equities. That backdrop makes this a fine time to give Old Europe a new look.