Despite the macroeconomic backdrop continuing to be very favourable over the fourth quarter of 2017, European equities tended to drift lower as the strength of the euro weighed on earning expectations. In the first week of January, the MAQS team established a long position in European equities in response to our perception of their increasing attractiveness.
One reason for our conviction on European equities is the strong global and European macroeconomic backdrop: The level of economic activity continues to accelerate in Europe. With PMIs at around 60, the environment for earnings growth remains solid (see Figure 1).
Figure 1. Earnings supported by the cyclical upswing
EuroStoxx trailing 12-month earnings growth vs. eurozone PMI
Data as at 10 January 2018. Source: IBES, Markit and BNPP AM MAQS.
Similarly, global growth continues to recover and is running above expectations, while interest rates generally remain subdued. This combination of high economic growth and low rates creates a very positive and stable environment for earnings expansion to provide the majority of returns in equity markets. European equities are trading at around their average historical valuation on a stand-alone basis, but look cheap when compared to other developed equity markets (see Figure 2). We do not anticipate large valuation re-ratings to drive equity returns at this stage of the cycle, but European equities do have some room for P/E multiples to expand, both in absolute and relative terms, compared to those of other equity markets.
Figure 2. Euro Stoxx valuations attractive vs. developed markets
Consensus forward 12-month P/E relative to the MSCI World index
Data as at 10 January 2018. Source: IBES, and BNPP AM MAQS.
Furthermore, our internal earnings models forecast marginally faster earnings growth than the consensus view for the next 12 months (+11% vs. +9%). The region stands to benefit from a continuation of the global expansion and should start to benefit from capacity tightness, which could further increase pricing power and hence margins, which have remained well below previous cycle highs (see Figure 3).
Figure 3.Euro Stoxx trailing 12-month net margin vs. eurozone producer price index, year-on-year
Data as 18 January 2018. Sources: Factset, BNP Paribas Asset Management.
The distribution of expected earnings growth is also healthy, with all sectors showing rising earnings next year, and no one particular sector providing the bulk of earnings expansion. Overall then, whilst the strength of the euro will dampen earnings growth at the margin, this factor is already reflected in European equity prices. What is not yet priced is the overall strength of Eurozone growth.
European equities are robust versus other equities
Heading into 2018 and for some time to come, we continue to believe we will be operating in a Goldilocks environment of low inflation and strong growth, which will be supportive of risk assets. However, we use a scenario based approach to modelling risk, and our two alternative scenarios are:
► Inflation surprise
► Global slowdown (“Three bears”)
Under the inflation surprise scenario, inflation gradually accelerates, primarily in the US and some EM economies, and this forces principally the US Federal Reserve to tighten policy, which in turn supports an appreciation of the USD and a weaker euro. Under this scenario, European equities remain relatively robust versus other equity markets.
Under the global slowdown scenario, all equity markets would undergo a correction, however the comparatively low valuation of European equities would offer relative support versus other markets. Therefore, we believe an overweight in European equities offers the most efficient means of overweighting exposure to risky assets.