18 February 2016

Against a backdrop of uncertainty and a rise in volatility in the financial markets, it is no surprise that eurozone business activity has slowed at the start of this year.

The latest reading for the eurozone manufacturing Purchasing Managers’ Index (PMI) came in at 52.3 in January, down from the previous month (53.2). However, it is still in expansionary territory – something that has been the case for well over two years nowi.

Credit cycle on the mend

Another positive for Europe is the credit cycle, which is on the mend thanks to an injection of liquidity into the economy by the European Central Bank (ECB): negative deposit rates and quantitative easing (QE) until at least March 2017. Despite global tail risks (most notably a slowdown in China and the US), we believe that the European economy – albeit from a lower base – is in better shape than other developed markets given the ECB’s support. ECB President Mario Draghi has also committed to providing additional monetary support if needed, hinting that he may take more action within the next few months.

Earnings expectations

Monetary policy alone, however, cannot solve Europe’s woes and questions remain over European earnings growth in 2016. Market expectations for 2016 appear relatively pessimistic, with consensus earnings-per share (EPS) estimates standing at approximately 4.5%ii. Such apparent lack of confidence last appeared during the 2008 financial crisis when EPS estimates fell below 4%.

While there are widespread global macro concerns which could curtail earnings growth in 2016, the recovery from the financial crisis in the eurozone is earlier in the cycle than other developed economies – and therefore may have further to run. Alongside a weaker euro that benefits European exporters, we believe that this offers some base for optimism.

Attractive valuations

At the same time, European equity valuations offer a significant discount to the US, with an increase of around 25% required to close that gap back to historic average levelsiii. It’s unlikely that all European industries will recover to historic levels of profitability – the world has moved on – so being selective at a sector- and security-level is going to be key for investors looking to capture this valuation opportunity.

Buoyed by a supportive central bank and valuations that look comparatively attractive (especially following the recent pullback), we believe that today European equities offer the most appealing relative prospective returns in the developed world – but stock selection is more critical than ever.

Source:
i Bloomberg, as at 05 February 2016
ii Barclays Research, DataStream, IBES, MSCI, 31 January 2016. 1-year ahead bottom up consensus forecast every December since 1988.
iii Credit Suisse, valuation discount of Europe versus US using Shiller PE, as at 31 December 2015.

CARS ref: RSM-3156
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of 05/02/2016 and may change as subsequent conditions vary.

Despite global tail risks, we believe that the European economy – albeit from a lower base – is in better shape than other developed markets given the ECB’s support.