Eurozone equities have traded sideways since peaking in May, but do they still look attractive over the long-term? Investors are wondering now about the recent euro rally and when a stronger currency could start to be a headwind for European companies.
The strong performance of the euro sends the message that the US dollar and by extension US shares are not the only race in town anymore. The recent euro rally is of a reasonable magnitude, but that is coming off the back of a 10 year bull run in the USD. As such, the return from non-dollar based assets may continue to go up from here.
Despite reaching multi-decade highs in the level of political uncertainty, European equities have generating something like 25% in EUR terms over the last year.
This divergence between heightened uncertainty and strong performance is because the market really cares about corporate earnings. In contrast to the pattern of the last several years, in which earnings have routinely disappointed lofty analyst expectations, this year analysts have been overly bearish and earnings have surprised to the upside, inverting what had been a negative downgrade cycle. There is every reason for that to continue.
In terms of how much higher earnings could go from here, relative to the US, Europe is still something like 20% below its pre-crisis earnings peak, suggesting there is quite a lot of room for further improvement.
Due to their high fixed cost base, European companies tend to have a lot of sensitivity to top line growth, so just a small positive change in sales can have a pronounced impact on earnings.
In terms of the outlook from here, there are two important themes to watch beyond earnings: underlying economic growth and valuations.
Eurozone manufacturing PMIs show that Europe is growing faster than the US and Euro area real GDP is fairly robust for Europe, all things considered.
We’re seeing significant strength in retail sales and consumer confidence. Industrial production is also increasing in Europe at a stronger rate than in the US. Improvement in labour markets, a rebound in manufacturing and a healthy consumer bode well for the European economic outlook.
Valuations on a relative basis also look fairly attractive. Europe currently looks cheap relative to US equities and the latest pullback enhances that cheapness.
If we consider the average dividend yield on European equities, cyclically adjusted over 10 years of dividend payments, then even considering European equities strong run year-to-date, investors could expect a moderate 5% to 10% average annualised return over a five year basis on European equities, if the historical relationship were to continue in the future.
As a final consideration, correlations in Europe are now below their historical long-term average. MSCI Europe realised sector correlations are currently at .51 compared to their average of .72. Lower correlations may highlight the stock selection opportunities for active managers.