Draghi's famous "bumblebee" speech and the creation of the Outright Monetary Transactions (OMT) program were landmark events in the management of the euro crisis as they helped remove systemic risk in Europe and, as a consequence, made European assets investable again.
From an economic perspective, Europe is showing signs of a tentative economic recovery. From an equity market perspective, we believe these improved fundamentals increase the likelihood of an inflection in European corporate profits toward positive growth. The past 12 months were about the revaluation of European equities from distressed levels, while the next 12 months will be more about a recovery in profits also driving positive returns further.
We want to focus on the European economic recovery, as this could be the catalyst to reverse some of the multi-year underperformance of European stocks.
How to participate in the region's improving economics?
With a J.P. Morgan Private Bank forecasted GDP increase of 1.25% over 2014, Europe is now acting as a tailwind to local companies' growth. Additionally, we keep in mind there are, alongside Europe, other higher growth areas of the world economy to which we would still want access.
These include the recovery in the US economy, which we expect to grow more than 3% next year, as well as continuing emerging market growth. Despite recent concerns about slowing EM growth, we think the long-term structural growth story remains in place with regards to consumption - for example, Unilever recently saw double-digit growth in its emerging market business for the ninth consecutive quarter.
As the crisis eases, there are other opportunities that start to become compelling: recovery, restructuring and refinancing. In order to reflect our shifting perspective on Europe in our portfolios, we started reducing our European underweight last year, following the announcement of OMT by the ECB. Recently we have continued to increase our allocation to Europe and further reduced our underweight as the macro fundamentals of the region have improved.
What are the potential risks to our current thoughts on Europe?
The key concern that we have had until now in Europe has been over its ability to deliver earnings growth in a weak economic environment. There are still some downside risks. Earnings expectations have come down in 2013 and 2014. The major risk is seeing profit growth returning later than expected, with further revisions to the downside possible if emerging market growth decelerates. A positive counter to this is the early sign of M&A picking up in sectors such as telecommunications, which could prove supportive for valuations while the market awaits a resumption of earnings growth.
Conclusion
For things to get better, they first have to stop getting worse. We believe the worst is behind Europe and that there are valid reasons to continue to be positive about the region. Fiscal austerity is fading, and we expect GDP growth to improve.
Even with this uptick, the opportunity for earnings upside is still broad, as manufacturing PMIs are now back on the rise, giving room for European profit margins to recover further. The central banks' continued support gives the region a stable framework and while we expect more hurdles for the banking sector, the overall institutional environment is more favorable than it was last year.
Within our own portfolios, we invested in line with our convictions and increased our European exposure over the summer. Going forward, there are a number of ways clients can access the opportunities we see in Europe. Broadly, we continue to like European companies with exposure to overseas markets and featuring secular growth opportunities. We believe it is also the time to consider domestic companies positioned to benefit from one or several of the European opportunities we described before: recovery, restructuring and refinancing.
Even as we have seen sentiment toward the region improve, most asset allocators remain underweight European equities, leaving room for additional inflows. We believe fund flows will act as a catalyst for the further rerating of stocks as Europe has become investable again.
Valuations are still supportive: the discount vs. US stocks is still more than 20% on a combined price-to-book and price-to-earnings basis. So far this year, the inflows into equity markets have been into the US and Japan, but the trend had started to shift.
While we have already increased our allocation, global investors' underweight to Europe has been a structural one. We acknowledge that it will take time to unwind this positioning, but the tide has begun to turn, creating what we view to be an attractive entry point for stock picking opportunities in Europe.
César Pérez is EMEA chief investment strategist and Rajesh Tanna is portfolio manager at J.P. Morgan Private Bank EMEA.
© Zawya 2013
