By Rob Burnett, Neptune European Opportunities Fund
In recent months, investors have become more pessimistic about both the European and the US economic outlook and yet stockmarkets have pushed on to new highs. Some would argue that this is a worrying divergence. We would take the opposite view. This appears to be classic bull market behaviour. A wall of worry has been rebuilt, and stockmarket resilience should be taken as a sign of strength. The market is discounting an improving economic outlook ahead, particularly in the south of Europe.
A sustainable recovery
The first quarter’s GDP data in Europe was mixed. Spain and Germany were a little better than expected, and France and Italy were a little worse. Europe’s mixed performance, coupled with a genuine growth scare in the US in the first quarter, made the market lose some confidence in the economic recovery in the developed world. Investors began to return to safe-haven investments that had performed well in the crisis.
However, we believe that the European economic recovery — including Italy’s — is very much on track. In southern Europe, the domestic demand recovery is at best six to 12 months old, having suffered through a six-year recession. Southern Europe is in a much earlier investment cycle than the rest of the developed world, allowing for longer above-trend GDP growth. Lower bond yields and lower unit labour costs are driving a ‘competitiveness-led’ recovery that we believe can generate good returns.
It would be a mistake to view all European countries as identical to each other. Investing in equities is not the same in all parts of the continent. For example, the Swiss index is dominated by large, globally exposed companies and Switzerland itself was very unaffected by the sovereign crisis. In contrast, we believe that Italy is a good proxy for ‘domestic’ Europe. While Swiss companies have relatively little Swiss and EU-derived revenues, Italy is a classic domestic-focused market.
There has been a lot of comment about the high valuations within peripheral European equities, typically citing the price-to-earnings (P/E) ratio for 2014. But the P/E ratio of peripheral European equity markets in 2014 is bound to be high. These countries have been through a massive recession where earnings have been decimated. If you look at the 2015 or 2016 P/E ratio, then peripheral European markets look better value as some of the earnings recovery is beginning to come through. Better still, focus on the price-to-book (P/B) ratio, where you ignore the cyclicality of earnings. Analysing the P/B of European indices relative to their own pre-crisis averages, Greece, Italy and Spain are extremely cheap.
This is particularly true of parts of the financials sector. Southern eurozone banks are the cheapest subsector on both P/E and P/B metrics, while they also offer the highest earnings-per-share (EPS) growth. We believe these strong fundamentals have underpinned the outperformance of the sector in the last 12 months and will help generate further alpha in the coming years.
We recognise that many investors are still concerned about capital within the banking system, and it is true that individual names such as Deutsche Bank are light of capital. Some Italian and Portuguese banks are still undertaking rights issues. However, we believe that the system itself is adequately capitalised. Data from the European Central Bank (ECB) analysing capital and reserves as a percentage of total liabilities shows a huge improvement in capital ratios since the crisis.
We prefer to invest in retail banks that do not do anything too complicated; companies that take deposits, lend money and make a spread. A comparable example from the UK would be Lloyds Bank. Lloyds has enjoyed a significant recovery in its return-on-equity (ROE) in the last few years, with a current ROE moving above 12 per cent. We believe that eurozone banks — which have ROEs of around six to seven per cent on average at present — will likely deliver a similar ROE to Lloyds in the coming years. This ought to drive a re-rating.
At Neptune, we are above consensus with our European GDP growth forecasts. We predict there will be better-than-expected data from Italy in the second quarter of 2014, and we also expect a pick-up in activity in Spain, Greece and Portugal. Having had a 25 per cent drop in real domestic demand during the crisis, Greece has the potential to surprise significantly positively in the coming years. We believe that value and earnings recovery in the domestic European economy can underpin higher share prices going forward, particularly in the domestically focused sectors such as financials, utilities and telecommunications.
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