Sentiment towards European equities has been on the rise this year. As the European economy continues to recover, investors have been buoyed by sustained earnings growth and a perceived reduction in political risk. We believe this should help counter any tightening of monetary policy, which will probably be modest, as well as the impact of a stronger euro.
The political uncertainty caused by a populist resurgence at the start of the year has receded, following the victory of centrist Emmanuel Macron in the French presidential election in May. Although German Chancellor Angela Merkel won a fourth term in office with a substantially reduced majority, she should make the necessary compromises to allow her to form a workable coalition. We also believe a solution will be found to defuse the Catalonia crisis.
The only real political risk now is the UK, where Brexit talks are deadlocked and sharp divisions within the Conservative party are preventing Theresa May from adopting positions acceptable to the warring factions. While we cannot predict the outcome, it is reasonable to assume that failure to engineer an amicable separation will hinder both sides.
There are some external uncertainties, too. They include the more opaque policy outlook in the US, which could have an impact on global economic expansion. Downside risks to growth in Asia, a major market for many European exporters, are also a legitimate concern.
However, investors have essentially looked through most short-term political concerns to focus on stronger economic fundamentals within Europe and a recovery in corporate earnings this year. The euro area economy is growing faster than America’s and the recovery appears broad-based. Any tightening of monetary policy by the European Central Bank should be limited as there are few signs of an acceleration of inflation.
Encouraging European Earnings Trend
Corporate results for the second quarter were reasonably encouraging, although the appreciation of the euro meant some earnings were more lacklustre than in the first three months of the year, reducing the scope for positive surprises. Nevertheless, earnings expectations have been trending upwards for the first time in six years.
In addition, we are still expecting upgrades in the third and fourth quarters of 2017, even if the earnings upgrade cycle now appears to be weakening slightly, because of the underlying strength of the economic fundamentals. Looking further ahead, we expect earnings growth to be slower next year, mainly due to the stronger euro and as companies in some sectors struggle to offset input cost pressures from higher prices of raw materials.
While many asset classes now appear to be fully valued, we believe further upside to European equities can be justified if progress on the corporate front can be sustained over the next couple of years. Despite a general increase in equity valuations, our focus on high-quality growth generative companies is well suited to Europe’s economic recovery and we are still finding good opportunities.
In this context, the telecommunications sector is interesting because consolidation is driving competition and boosting margins. So, too, is the financials sector. We believe banks are generally undervalued and stand to benefit from tighter monetary policy signalled by the ECB. We also like software providers. Some of these companies have delivered excellent rates of compounded growth. Secular trends such as the increase in online spending and greater efficiencies in financial companies will drive expansion at a similar pace in years to come.
Outside of these areas, the way we value company shares is conservative and finding stock-specific investments that offer material upside on our approach has become harder over the past year. From this perspective, we would welcome a shakeout in the market in order to present new opportunities.
Disclaimer
The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring on our website, please email submissions to UKEditorial@morningstar.com
