Time for a Roman Holiday?

The 1950s film Roman Holiday displays the full splendour of the Italian capital and for good measure features a fairy-tale romance between characters played by Gregory Peck and Audrey Hepburn.

Whether the British are quite so in love with the Eternal City, or the 1957 Treaty of Rome, remains a more open question, at least after last June’s referendum result, but last weekend (25 March) the Eurozone celebrated the sixtieth anniversary of the signing of the document which created the European Economic Community (EEC), the forebear of today’s European Union (EU).

Sixty years of peace have followed and the EU has continued to develop and grow but it now faces perhaps some of its greatest challenges, politically, socially, economically and financially in the form of:

  • Elections in France and Germany in 2017.
  • The ongoing Greek debt drama, the latest act of which is set to culminate in July’s latest bailout repayment deadline.
  • The ongoing Italian debt drama, where attempts to support the country’s banking system are proving to be inadequate.
  • The UK’s vote to leave and the Prime Minister’s determination to do so by March 2019.

So far, an alphabet soup of institutions and policy initiatives – including ESM, EFSF, ABSPP, SMP, LTRO, TLTRO and finally QE, not forgetting ZIRP and then NIRP* - have helped steer the EU through some very choppy waters.

Advisers and clients may therefore be considering whether it is time to cross the English Channel once more and revisit their European equity exposure within portfolios, especially as Eurozone stocks are still nowhere near their pre-crisis highs and valuations look attractive relative to the US, in absolute and relative historic terms.

Eurozone stocks still trade below their 2000, 2007 and 2015 highs

Source: Thomson Reuters Datastream

The good news is that any advisers or clients who feel the valuations on offer mean a lot of the still-palpable risks are priced in have plenty of choice when it comes to funds that offer exposure.

Best performing Europe ex-UK Large Cap Equity ICVCs over the past five years

(Where more than one class of fund features only the best performer is listed.)
Source: Morningstar, for Europe ex-UK Large-Cap Equity category.

Best performing European investment companies over the last five years

(* Share price. ** Includes performance fee)
Source: Morningstar, The Association of Investment Companies, for the Europe category.

Best performing Europe Large Cap Blend Equity ETFs

(Where more than one class of fund features only the best performer is listed.)
Source: Morningstar, for European Large-Cap Blend Equity category.

Winners and losers

The 1951 Treaty of Paris established the six-nation European Coal and Steel Community (ECSC) and the 1957 Treaty of Rome saw the same six member nations – Belgium, France, Italy, Luxembourg, the Netherlands and what was then West Germany – create the European Economic Community.

Further developments, via the 1992 Treaty of Maastricht and 2009’s Treaty of Lisbon, have changed the name, helped add to the membership, establish a single currency and forged the foundations of what is now the European Union, a bloc with far loftier ambitions and higher goals than 1951’s coal and steel cartel.

Although the sixtieth anniversary celebrations will see heads of state converge on Rome for a summit once more, the event will be clouded by the still-substantial challenges which confront the EU, not least how friction with Russia, the migration crisis and the UK referendum vote mean six decades of geographic expansion looks to have come to an end, with 2012’s association agreement with Ukraine in abeyance, relations with Turkey cooling and the UK preparing to leave.

Europe also faces political, social and economic challenges, of which unemployment is perhaps the biggest.

The chart below shows the change in unemployment, in percentage points, across the 12 countries that first adopted the euro as their physical currency in 2002 across the intervening 15 years.

The winner – Germany – is as easy to identify as the losers (Greece, Spain, Portugal and Italy).

Germany has been the big jobs winner in the EU since adoption of the euro

Source: Eurostat

In broader economic terms, there have been winners and losers too. Using growth in annual GDP (constant prices) between 2002 and 2016 as a yardstick, Ireland, Austria, Belgium, Germany and even Spain have done relatively well. Portugal, France and Italy have stagnated. Greece has suffered.

Southern Europe has done less well than the north in GDP terms since 2002

Source: Eurostat

This disparity is also reflected in stock market performance across the 12 original euro adopters since 2002. Austria and Germany have revelled in the age of the euro. Investors in Italian, Portuguese and Greek stocks have, overall, done badly.

Southern Europe has done less well than the north in stock market terms too since 2002

(*Total return in euro terms, from 1 January 2002 to 20 March 2017)
Source: Thomson Reuters Datastream.

This mixed bag of returns may help to explain why Western Europe, as benchmarked by the Euro Stoxx 600, ranks seventh out of eight major geographic areas since 2002, in total return, sterling terms. Only the UK comes behind it, perhaps as a result of its dependence upon financial services and the damage done by the 2007-09 crisis, as well as the predominance of unpredictable mining and oil stocks in the FTSE All-Share index:

Eurozone stocks have performed relatively poorly since the adoption of the single currency in 2002.

(Total returns, in sterling terms.)
Source: Thomson Reuters Datastream.

Contrarian case

Yet those advisers and clients who are natural contrarians will be tempted to argue this underperformance means there could be a valuation opportunity to be had, especially as the list of Eurozone woes and performance indicators above hardly constitute as news.

Research from Société Générale’s strategy team makes such a case, asserting in a lengthy analysis just this week that “Eurozone equities are currently trading at a 47% discount in price-to-book value relative to the US market, compared to a 40% discount over the last ten years and 29% the decade before. Today, all sectors in the Eurozone are trading at a significant discount to their US peers: from 26% for the Health Care sector to 60% for Consumer Discretionary.”

SocGen then adds: “On top of the valuation gap, the currency has weakened: the euro has fallen by 33% versus the US dollar over the last decade.”

If advisers and clients take this at face value, they may be intrigued by Europe, but will still then have to find the potential catalyst for a re-rating of Eurozone assets.

There may be some positive signs here.

Inflation and growth seem to be improving, key sentiment indicators are on the turn and stock markets are back to December 2015 highs. The Dutch election did not turf out Mark Rutte’s four-year old government as many had feared, although the anti-EU PVV party did come second, and The European Central Bank has even laid the ground for reducing the size of its monthly QE scheme from €80 billion to €60 billion from April.

JP Morgan Asset Management can also divine some shafts of light amid the existential gloom.

“There are two important reasons to expect an end to the earnings recession,” suggests Stephen Macklow-Smith, European equity fund manager and strategist, as he asserts that that both real growth and inflation are rising in a synchronised global recovery, meaning that nominal growth will be better than it has been for many years.

“The magic level for sales growth (which maps onto nominal growth) is around 2.5%. Below that level margins contract but above that margins expand, so this year should see better top line and better margins,” he argues, adding: “The second reason is that there has been a rolling earnings recession across a variety of sectors, notably banks in the run-up to the stress tests, energy and commodities in the last two years because of falls in product prices .... This year those extraneous effects are absent so we have clean growth across a number of areas.”

Three-point check list

In sum, JP Morgan Asset Management makes a case for an end to Europe’s earnings recession. This may explain why the Eurozone is so far outperforming the US in 2017, even if Emerging Markets are still showing it a clean pair of heels:

Eurozone stocks have beaten the US and other developed markets so far in 2017

(Total returns, in sterling terms to 22 March 2017.)
Source: Thomson Reuters Datastream.

To see if this (initially modest) renaissance can continue, advisers and clients may find it useful to follow three particular indicators:

  • Target 2. Target stands for Trans-European Automated Real-time Gross Settlement Express Transfer system. In essence the system is there to help balance trade flows but it also reflects capital flows – if a Spaniard parks cash with a German bank, the Spanish bank that lost those deposits now gets Emergency Liquidity Assistance (ELA) , or funding from the ECB via an open credit line to make up for the loss of that cash. This is all well and good unless the recipients of that ELA funding default – as other EU members would share that pain.
  • What Target-2 data is showing at the present seems to be huge capital flight from the South to Germany. This is a result of fears over the Greek and Italian economies in particular and whether politics could give anti-EU parties a chance to lead in France after the May election and Italy after 2018’s scheduled ballot, potentially threatening their membership of the Eurozone. Any calming of these concerns could see Target-2 flows reverse, something that would suggest economic, banking and political strains are easing (equally further flows from South to North could be a worrying sign of fresh existential dangers):

Target-2 data suggests European financial system is still under duress as money flows north

Source: European Central Bank

  • Banks. As discussed in this column before (17 February) Italy’s banks are a mess and the €25 billion in Atlante bail-out funds provided to cover €284.4 billion in non-performing loans at Italy’s 14 biggest banks is totally inadequate. Deutsche Bank’s cheeky move to raise fresh capital less than six months after claiming it did not need any is a further warning that Europe’s banks remain fragile and its stress tests unreliable. A healthy banking system would be of huge benefit and in fairness the sector index is trading near December 2015 highs, so further progress here would be a potentially encouraging sign (although fresh declines could therefore have more ominous implications).

Eurozone banking stocks remain a key indicator for broader financial market health and sentiment in the region

Source: Thomson Reuters Datastream

  • Belgium’s Courbe Synthétique. Industrial confidence surveys such as those run by the Ifo and ZEW in Germany and the purchasing managers indices (PMIs) prepared by Markit Economics may be better known but Belgium’s Courbe Synthétique looks to be an uncannily useful guide to the fortunes of the Euro Stoxx 600 index. Quite why the views of 6,000 Belgian industrials provides such a keen insight into Europe’s equity market and economic fortunes may itself be a matter for debate on another occasion, but the results are hard to deny. The outcome of the business sentiment survey are released on the National Bank of Belgium’s website on around the twenty-first of each month and it can provide a succinct insight into Europe’s business fortunes.

Belgium's Courbe Synthétique is a good indicator for Eurozone equities

Source: National Bank of Belgium, Thomson Reuters Datastream

Bulls of European equities will be pleased to see that the dip witnessed following the UK’s vote to leave the EU now looks like a blip, although the generally upward trend is wobbling a little, as judged by the March reading of -1.6, the second consecutive drop, according to data released last Thursday (23 March). If the reading slips consistently through spring, we could see this unheralded Belgian become a little more famous, albeit for the wrong reasons.

* ESM – European Stability Mechanism
EFSF – European Financial Stability Facility
ABSPP – Asset-Backed Securities Purchase Programme
SMP – Securities Markets Programme
LTRO – Long-Term Refinancing Operations
TLTRO – Targeted Longer-Term Refinancing Operations
QE – Quantitative Easing
ZIRP – Zero-Interest Rate Policy
NIRP - Negative Interest Rate Policy

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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