February 20, 2014
|Dean Tenerelli, portfolio manager of T. Rowe Price's European equity strategies.|
Despite market weakness early in the year, the European macroeconomic picture is beginning to improve, as seen by data in manufacturing and other economic indicators. However, European corporate earnings have yet to materially recover.
Dean Tenerelli, portfolio manager of T. Rowe Price's European equity strategies, highlights why the renaissance for European equities can continue and why he believes that corporate earnings will provide the next leg for the recovery.
Improving macroeconomic backdrop...
- Leading economic indicators and actual economic data are pointing toward an improving macroeconomic picture—something we have believed for some time now.
- Along with the news that the region has now started to grow again, we have also seen manufacturing indicators surge in recent months. We believe that European economies troughed somewhere during the second quarter of 2013.
…driven by structural reform across the region
- Structural developments and rebalancing efforts continued to materialize throughout the European region, especially within the periphery. Current account balances have returned to surpluses and now stand at 15-year highs. Meanwhile, unit labor costs continue to trend lower, signaling further improvements to competitiveness in the region.
- Countries have behaved much more responsibly than they have been given credit for. Ireland is a good example. Ireland suffered from a sharp loss of competitiveness as negative real interest rates overstimulated the economy. However, since the global financial crisis, Ireland has responded quickly through internal devaluation by instigating wage cuts and pension and labor reforms in order to regain competitiveness. Many other countries within Europe have echoed that same trend, which is bringing competitiveness back to the eurozone.
Positive fundamentals to guide the recovery
- Europe has taken advantage of the crisis to make some hard reforms, and these have been completed without having to depreciate the currency.
- The strength of the euro should be seen as a sign of confidence in the region, not only in its long-term sustainability, but also in the encouraging current structural and economic progress. These same fundamentals will be what guides the recovery.
- Currency strength should be expected to have some adverse competitiveness effect on European companies, although higher-quality companies will be better placed given their product and pricing strengths. European policymakers are very mindful, though, of not allowing any further euro strength to derail the current recovery, and policy actions are likely to be forthcoming if we see renewed strength from here.
Recovery beginning to filter through into corporates
- The recovery has yet to materially affect corporate earnings, but we fully expect this to happen. Indeed, we are encouraged following our recent meetings with companies to discuss their earnings.
- From an industrial standpoint, from a confidence standpoint, and from a consumer standpoint, we believe that everything we are hearing should feed through into companies in which we are investing.
- European companies also meaningfully restructured after the crisis, reducing costs and improving their market positions. Therefore, we believe that many companies will experience significant operational leverage as the recovery gathers pace.
European renaissance underpinned by reasonable valuations
- Valuations are where it becomes interesting. The market has already discounted in advance some of the recovery, and this is what has helped drive the market over the last year and a half.
- However, we have to remember that we have endured a deep crisis, and equity markets have suffered for a number of years. European markets became very cheap. So even though markets have risen strongly over the past year, we believe they still have much further to go, supported by a revival in corporate earnings.
- Currently, on a cyclically adjusted basis, the P/E ratio for the European market is below 14 times versus a longer-term average of nearly 20 times. As this measure utilizes the average of the last 10 years' earnings, we believe it is a useful indication as to the market's attractiveness, assuming a normalized level of earnings. At present, earnings are appreciably below the level registered before the financial crisis of 2008-2009.
Wealth of opportunity across the region
- We are finding great opportunities within Europe, reflecting much of the corporate restructuring that has taken place. It is also important to remember that half of the revenues from companies in the MSCI Europe Index are generated outside Europe. Europe is, therefore, a great way to be exposed to global trends, whether it is emerging market consumers or different sector trends within technology.
- Europe also has great small- and medium-sized companies, many of which are family-owned businesses that run the companies for the long term, have a strong cash position, and are willing to invest through downturns. Many of these companies had strong balance sheets going into the crisis and had cash to invest in the downturn, so they have come out of the crisis much stronger.
- There has also been a lot of consolidation in Europe, particularly within the banking sector. In Spain, for example, there were about 60 regional banks prior to the crisis; now there are 11 in the country. Financials is also a great way to play positive momentum building within the eurozone.
- There are also exciting investment areas within the media sector. We are particularly upbeat about European broadcasters, where many companies in this cyclical grouping have been penalized by investors because of excessive concerns about the state of domestic economies, most notably in Spain and France.
Europe remains a diverse region, offering investors access to market-leading global franchises
- Despite the challenging road ahead and the need for fiscal convergence, Europe remains a diverse region with many high-quality companies with great pedigrees and robust balance sheets. Many of these are trading at a significant discount to their global peers. The corporate sector is also in robust shape-supporting capital expenditure, mergers and acquisition activity, and income and earnings growth.
- Fear is subsiding, and there remains a lot of potential upside, even despite the strong returns we have enjoyed so far. Many European countries have also faced up to challenges in recent years and undertaken difficult but significant structural changes that should provide meaningful improvements in the future. Most encouraging for us, though, is that corporate valuations do not yet reflect normalized earnings, so there remains great potential for stocks to move further ahead.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of February 5, 2014, and may have changed since that time.