We See Opportunities Across the Atlantic
Our basic view on the U.S. market remains positive. As we’ve written in recent letters, we believe that the post-election rally doesn’t just reflect the optimism of businesspeople and consumers about positive developments in U.S. tax and fiscal policy. Midway through last year, markets were already beginning to reflect the passing of the dollar and oil shocks of 2014 and 2015 — the impacts of a large and sudden rise in the value of the U.S. dollar, and of a large and sudden fall in the price of oil. The arrival of a new administration after a bitter and divisive election campaign served to underscore the turn, and sentiment helped propel the stock market rally, even if it was not the rally’s fundamental support.
Now markets are pausing and digesting the rally. As we have said, with the positive fundamentals still intact, and with sentiment indicators still continuing strong, we remain buyers of any normal correction. We do not see imminent risk of recession or the arrival of a recession-driven bear market.
U.S. Markets Respond to the Legislative Process
Market sentiment does not seem to have been very adversely affected by the new administration’s first legislative defeat — the failure of its bid to repeal and replace the Affordable Care Act. We did not believe that the effort to repeal Obamacare represented a real priority of the President. Rather, we thought he embarked on it first as a deal with more ideologically driven Congressional Republicans, in the hopes that it would smooth the way for the items he cares more about — particularly corporate tax reform and infrastructure development. Those items are not just more personally important to the President — they’re more important to the markets. With the health care push done for now, all eyes are on the next legislative items — and the stakes are certainly higher.
We are cautiously optimistic that if the administration’s heart is really in the push for corporate tax reform, there is significantly more scope to draw in cooperative legislators from both sides of the aisle. We remain prepared to adjust our investment strategy appropriately as we continue to monitor the political and economic environment in the U.S.
However, in recent conversations with our clients and colleagues, we have often been asked where else we can look for opportunities should the market environment in the U.S. become more challenging. One key region we are examining is Europe.
Europe: Like the U.S., Turning the Corner
Sentiment on Europe among global investors remains suppressed. We understand why: we have often commented on Europe’s woes in these pages.
Here’s a recap. After the global financial crisis, Europe was hit by sovereign debt crises in Greece, Portugal, and other peripheral countries — with the threat that even Italy and France might not be immune to similar problems. Throughout Europe, populist movements have gained traction in response to these crises, and in response to unmanageable migrant inflows, stagnant growth, and high unemployment. These populist movements have imperilled the integrity of the Eurozone, threatening to pull several countries out of the common currency if they gain power and raising the specter of true financial chaos in that eventuality. The European banking system remains relatively weak and undercapitalized, in contrast to the U.S. banking system, which has placed itself on much firmer footing in the wake of its 2008 “near death experience.” In response to these conditions, the European Central Bank has pushed interest rates into negative territory, a financial experiment with as-yet-undetermined consequences. And meanwhile, on Europe’s eastern flank, an emboldened Russian bear continues to test NATO’s resolve with swagger and provocation, threatening the return of a cold war.
That sounds like a lot of negatives. And yet, Europe is experiencing an acceleration of economic fundamentals and of sentiment much like what’s happening in the U.S. With one significant difference: European stocks have priced in a lot less optimism than their U.S. counterparts.
Here is a graph showing the 12-month forward price-to-earnings multiples for the U.S. stock market (the S&P 500 index), the German stock market (the DAX index), the French stock market (the CAC 40 index), and the broad European stock market (the EuroStoxx 50 index).
Source: Bloomberg
As you can see, the valuation multiple of the U.S. market has continued to expand (with hiccups) since 2011. On the other hand, Europe’s valuation has moved sideways since 2014.
Currently, on the basis of next-12-months earnings estimates, France trades at a 17.7% discount to the U.S.; the EuroStoxx at an 18.3% discount to the U.S.; and Germany at a 22.9% discount to the U.S.
These European markets have appreciated since last year, but are still not pricing in the full extent of improving fundamentals. Inflation, GDP growth, and sentiment are all trending higher and accelerating.
For example, recently released composite European PMI numbers continue to show acceleration.
Source: Bloomberg
The PMI, or purchasing managers’ index, is a sentiment indicator calculated by interviewing business managers about their outlook on a slate of growth and business performance metrics. So it is a “soft” indicator, but one with historical value in capturing economic dynamics that have not yet shown up in lagging official statistics. Analysts are seeing nascent upticks in GDP growth, and beginning to increase their outlook — especially in the context of the emerging “global reflation.”
More positive data have shown up in other sentiment indicators. European businesses are getting bullish, like their U.S. counterparts.
Source: Bloomberg
And so are European Consumers.
Source: Bloomberg
How Big Is the Political Risk?
Markets may not be pricing in Europe’s participation in the world’s growth inflection because of the perceived overhang of political risk.
After last year’s crescendo of political surprises — including the Brexit vote and the U.S. political election — analysts have been cautious about writing off upcoming political developments in Europe that could be disruptive. The Netherlands roundly rejected the populist insurgency of anti-immigrant firebrand Geert Wilders in their recent election. Now all eyes are on France, as nationalist Marine Le Pen — who has pledged to pull France out of the Euro — faces down her main rival, Francois Fillon, an establishment candidate weakened by scandal. It looks unlikely that she will achieve a victory even if she makes it to the run-off round in May. But after the Brexit and Trump surprises, who will go out on a limb to make that claim with conviction?
Without venturing a prediction about the French election, we will make a few observations. Even if she wins, Ms Le Pen’s political clout will be weakened by her party’s pariah status: no other parties will cooperate with her agenda, and the Front National does not have the votes to push it through alone. Perhaps Wilders’ defeat in the Netherlands marked “peak populism” in Europe — but even if it did not, we think it is unlikely that the Euro will be collapsing from political pressure any time soon. As we have often observed, the devotion of Europe’s elites to the European project is deep. They will not give up easily. And they are not weak.
With all that said, we are cautiously optimistic that the improving fundamentals will overcome fear of political turmoil in Europe. Those improving fundamentals — inflecting GDP growth and inflation — could also permit the ECB to normalize policy in a gradual manner that will be helpful for European banks.
With European stocks at such a discount, we remain alert that if the environment in the U.S. becomes less positive, we can still look across the Atlantic for investment opportunities. As in the U.S., we are aware that a correction could happen in Europe at any time.
Investment implications: European stocks have not recovered nearly as robustly as U.S. stocks in the period since the Great Recession. The Eurozone’s markets still suffer from an overhang of negative sentiment — especially in the wake of Brexit, and in the face of upcoming French elections that could see the victory of anti-European nationalists. Still, underneath this negative view, we see Europe participating in the global growth inflection. Business and consumer sentiment and outlook indicators, and hard data “green shoots,” suggest that accelerating GDP growth and inflation are on the way. After the defeat of the Republican effort to repeal and replace the Affordable Care Act, the U.S. market is looking forward much more eagerly to tax and regulatory reform and a robust infrastructure program. If the U.S. market environment gets more challenging — especially if those high-profile reforms are delayed — we’re looking closely at Europe.
