Europe's economy is already stronger than you think: now watch the money flow back for double-digit returns

Stephen Macklow-Smith
German Economy Showing Signs Of Recovery
Stronger growth will lead to higher returns (Source: Getty)

We now have solid data to suggest that global growth is becoming more synchronised – with the recovery gaining steam in key emerging market economies as well as in Europe and Japan, the latter two regions of which keep seeing their growth forecasts revised upwards.

US equities have outperformed the rest of the world more or less continuously for the past five years and emerging market economies are now starting to bounce back from the pressure of commodity price declines and from dollar strength. At the same time, the economic case for Europe has strengthened since the start of the year and political risks are beginning to wane.

It’s already better than you think it is in Europe. Inflation is recovering, so nominal growth is picking up. Company revenues are a nominal rather than a real measure, so the relief in pricing pressure is good for margins and good for earnings.

Read more: Whisper it, but the European economy is in surprisingly good shape

While political uncertainty has been a concern for Europe, the real problem has been the lack of earnings growth. The S&P 500 at the end of last year was at a 40-year high versus the European index, with well over 100 per cent of outperformance in the last eight or so years, driven by better relative earnings performance and by re-rating.

The same movie has played out in each of the last several years – the year starts out with investors expecting European earnings to grow by 10% and then they actually end up shrinking. Now, however, we really do think this time is different and we’re turning a corner. When tangible growth is finally delivered, that should lead to some of that underperformance being recouped.

If we assume that earnings rise in line with analyst estimates of approximately 14 per cent, and that the valuation does not change, then investors would get the growth in earnings plus the starting dividend yield of approximately three per cent. That translates into a respectable mid double-digit total return for Europe in 2017.

Read more: Draghi: Risks to the Eurozone becoming more "balanced" as ECB holds policy

Cyclical sectors that are more sensitive to economic conditions have also been out of favour over the past five to six years, a time when earnings for the overall economy were flat, and more defensive high-quality consumer names were in favour. Certainly, Europe is more cyclical, more exposed to global growth and to emerging markets. So while these have been headwinds in the last few years with growth disappointing, they are slowly turning into tailwinds.

Unfortunately investors have remained cautious towards Europe as a result of political uncertainty, while watching this improvement in economic data. But with 2017 set to be the year where much of the political risk does not eventuate and economic fundamentals are strong across the region, this dynamic is beginning to create a wealth of attractive opportunities for those who are willing to select internationally competitive stocks at attractive valuations.

Since January 2016 approximately 15 per cent of total assets in European equities flowed out of the asset class, but in the last few months flows are on the turn.

Read more: Eurozone growth remains steady as economic recovery continues to roll on

Generally, in the last six to nine months, we’ve seen a tremendous vote by the equity markets in favour of reflation. A year ago we were on the edge of deflation and now we’ve come a long way and are taking a more optimistic view – we think the reflation trade is holding, even if markets never go in a straight line.

Europe gives you more exposure to reflation and more upside in terms of profitability and you’re paying a much lower price to participate than you are buying US stocks.

With all of this in mind, we expect a decent proportion of those previous outflows to flow back into the asset class as the year progresses.

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