What's not to like?
A European bear case
It’s easy to build a buy case for European equities at the moment. The economy is booming, earnings are growing, politics look as stable as they have been for years and the European stock markets have lagged behind for so long that surely it’s time for some catch up? But perhaps constructing this buy case is a bit too easy?
To me, these and others are good enough reasons to be long European equities (for more on my view on the bull case see my guest blog in Commerzbank's Thinking Ahead), and surveys suggest that most investors agree with this view. When that happens it’s time to test the bull case and take the ‘what’s not to like’ question literally. Here’s a look at a few of the potential stumbling blocks, although this is by no means a complete list.
The political calm could end. The most obvious candidate for some political risk returning to European markets is the Italian election, expected to be held in the spring. Recent newsflow suggests that concerns over the Five Star movement may be receding somewhat; their support has dropped in the polls and the party has been showing signs of softening its rhetoric on abandoning the euro. However, below the surface of this year’s election wins for centrist parties, populists increased their vote share in all instances. It may be wrong to interpret 2017 as a turning point in the rise of European populism.
There may have been better newsflow on the European earnings front, but after years of disappointment, some remaining scepticism seems warranted. There has been a top-down case for above-average earnings growth for longer than just the past year and reality has often not lived up to the promise. There is a risk that this time won’t be different and that perhaps the stronger euro will eat up more of the earnings growth than expected.
Our base case is that the gradual reversal of quantitative easing will not be a significant negative for equity prices in general or Europe in particular. But given the lack of historical precedent, we need to be humble enough to accept that we cannot know for certain.
Potentially the greatest disadvantage for European equities is that they have almost no exposure to the technology sector. If shares in technology companies continue to outperform broader markets, this would be a significant drag for Eurozone equities compared with tech-heavy regions like the US and emerging markets.
This could become an even bigger issue if equities move into bubble territory via a big pick-up in flows into equities from retail investors; this is not our base case, we don’t think we’re at the peak of the market cycle, but it is also not an implausible scenario. Retail flows like a good narrative and our best guess at what that narrative might be is technology.
Valuations often get mentioned as a buy argument for European equities. While I don’t think that valuations are likely to hold back performance, their importance as a buy argument is often overstated in my view. On most measures, the discount of European equities compared with other regions isn’t unusually large. They do look extremely cheap on a cyclically adjusted PE basis, but there are many reasons not to put too much weight on this particular outlier multiple. And it’s important not to forget that valuations are typically pretty useless as a tactical tool; there is no historic correlation between valuations and short-term returns.
Finally, we believe that European equities could be one of the worst places to be in the next downturn. European equities’ cyclicality could work against them and the experience in the last downturn revealed that the Eurozone’s institutional framework is not designed to respond to a crisis in size and with speed. The next crisis could also bring back concerns about the integrity of the European Monetary Union. We don’t think this is an imminent concern, but the risks of a recession are notoriously difficult to predict.