Time For Bargain-Hunting In Europe?
On Sunday and Monday we heard about two new polls in the U.K. — both showing the “leave” vote pulling ahead of the “stay” vote in the contest to determine whether Britain will remain in the European Union. The momentum was visible also among the U.K.’s book-makers, with London online gambling outfit Betfair showing a 28% chance of Brexit as of this writing, versus 19% last week. The pound reacted poorly on Sunday, but British markets were more sanguine when trading opened on Monday, and the currency reversed its previous losses.
In spite of the new polls, we continue to think that British departure from the E.U. is unlikely, for several reasons. We’ve gotten helpful perspectives from some friends and colleagues in the U.K. They note that Prime Minister David Cameron has a reputation even from political opponents as a canny political tactician; it is unlikely that he would have called the vote at this juncture if he didn’t think he would win it. He knows that demographics are working strongly in his favor. The city of London and its commuter belt have 14 million residents, 22 percent of the U.K.’s population, and will swing heavily to a “remain” vote. Scotland and Wales, with about 8.5 million residents between them, have palpably benefitted from various E.U. programs, and will also provide strong support for Cameron. (The Scots always love an opportunity to confound the right wing of the Conservative Party.) In the rest of the country, votes will fall along economic lines, with working-class ethnic Britons who have suffered most from immigration and globalization forming the backbone of the “leave” vote — but we doubt that this group is strong enough to carry the day. We think that “remain” will win on June 23.
Source: Bloomberg
European Opportunities
Our regular readers also know that we see many medium- and long-term problems for Europe. To sum up:
- European business dynamism and productivity growth will continue to be impaired by individual E.U. countries’ large welfare states and onerous regulatory regimes.
- In one way, Europe is insufficiently integrated — it has a common currency and monetary policy, but each member state largely has its own fiscal policy. Although the Union is struggling towards a coherent framework of bank regulation, it has not yet achieved that goal. The tensions that result from this half-union are chronic and could lead to a financial crisis at some point in the not-too-distant future.
- However, in another way, Europe is far too integrated — not by critical regulatory frameworks, but by the growth of a bureaucracy which can be oppressive, opaque, arrogant, and unaccountable to ordinary citizens and voters.
- Europe is dealing with an inflow of refugees and economic migrants which is straining to the limit their capacity to integrate these new arrivals. Indeed, that capacity was questionable even before the new influx — poorly integrated migrant communities across the continent continue to pose risks to cultural cohesion, social trust, and basic security, as evidenced by recent terror attacks and threats as well as ongoing simmering tensions, particularly in France, Belgium, Sweden, and Germany.
- Public resentment against slow growth and the migrant flood have contributed to the rise of populist right-wing parties across the continent. Their showing has been strongest in Eastern Europe, where such parties have taken power in Poland and Hungary. They are making electoral strides in France, Austria, and Germany. These parties are fiercely skeptical of the current direction of ongoing European integration, and their rise creates uncertainty and volatility.
- Finally, let’s not forget Russia. A resurgent Russia threatens what seems like an old and tired NATO alliance which has come to rely almost exclusively on the United States, and to a degree, the U.K., for its fighting spirit. Most European nations have been negligent about their defense budget obligations to NATO, and the alliance is unprepared to deal with Russian aggression against member states, according to many analysts. Seasoned and realistic observers see the Baltic states especially in Russian cross-hairs.
(The U.K. is fortunate not to suffer from these problems as much as their continental brethren — which is one reason why we hope they chart their own course and send a clear message across the channel.)
So those are all the negatives. Nevertheless, continental Europe, with all those woes, may be cheap enough to warrant an investment.
The European Positives
Simply looking at the charts, while the S&P 500 is near its old highs of a year ago, the major European indices are all weaker.
Only Denmark and Ireland are near or above the levels of 12 months ago. In U.S. dollar terms, the broad EuroStoxx index is down about 12%; Germany and France are down about 8% each; Sweden and Switzerland are down about 13% each; Spain is down about 18%; and Italy brings up the rear, down more than 21%.
Source: Bloomberg
Aside from Brexit, there are no pressing and immediate catalytic events in store for Europe. If the U.S. market finally succeeds in breaking out above its old highs — pushed for example by higher earnings anticipations caused by a stable-to-falling dollar, the ongoing recovery of the energy sector, nascent inflation, and the fading of fears about a Chinese-driven global recession — Europe, cheap by comparison, could also be lifted out of its doldrums. European markets could attract funds simply because they have been relative laggards.
Despite the negatives mentioned above, there are also positive fundamentals emerging. European economic growth is picking up; the most recent data from Eurostat show the Eurozone economies growing at an annualized real rate of 1.7%. This is the most robust rate of growth since 2010 — before the Eurozone debt crisis of 2011. Should these data continue strong, they would also help shift investor psychology back to looking at European markets.
Currency Is Stable-to-Rising
In the lead-up to the initiation of a quantitative easing program by the European Central Bank (ECB), the value of the common currency declined dramatically. It bottomed last April, as measured by the basket of trading partners’ currencies tracked by the ECB. It is now in the upper half of its channel:
Source: Bloomberg
Given the different dynamics at work for the euro and the dollar, we feel that the currency exposure of a position in European stocks would be neutral or a net positive in the near term.
Is It Cheap?
Historically, most European markets have been cheaper than the U.S. The table below shows the long-term average forward price-to-earnings estimate for European markets. (We have averaged ten years’ worth of estimated earnings looking out to the next full calendar year. For example, right now, this would compare present prices to anticipated 2017 earnings.)
Source: Bloomberg
Right now, by this metric, U.S. markets are rather expensive compared to their history, with the S&P trading at 15.79 times 2017 earnings estimates, a 16% premium to its 10-year average. European markets have also appreciated since the financial crisis, are generally not so expensive compared to their history.
Data Source: Bloomberg
However, although European markets have historically been cheaper than U.S. markets, that spread has widened — they are now relatively much cheaper than they have been over the past 10 years.
In short, among European markets, all except Spain and Denmark are trading significantly cheaper than their historical discount to the U.S. market.
Ireland, which over the past 10 years has traded at an average of an 18.1% premium to the U.S. market, is now trading at a 6.2% discount. Even Germany, Europe’s bill-payer and economic stalwart, has historically traded at a 17.8% discount to the U.S. — and now trades at a 31.2% discount.
Green figures represent a discount; red figure a premium.
Data Source: Bloomberg
One of our themes for the year is reversion to the mean. In Europe’s case, such a reversion would indicate a move back towards recent historical patterns of performance relative to the U.S.
Yes, Europe continues to have the significant macro overhangs we mentioned. We note especially that the European indices are heavy with financial companies, and Europe’s negative rates do not spell profits for banks, to put it mildly. So in the medium to long term, we continue to have reservations about Europe, and would certainly not be long-term buyers at this point. However, in the near term, Europe could be cheap enough to enjoy a reversion-to-the-mean rally — particularly if the U.S. market finally succeeds in breaking out to new highs and improving global risk sentiment, and if Eurozone GDP growth continues on the positive path it has taken thus far this year. We would certainly wait for the Brexit vote to pass before looking for an entry point, however.
Investment implications: Most European markets have historically traded at a discount to U.S. markets. Our analysis of forward estimates over the past 10 years, however, shows that this discount has become significantly larger. Aside from Spain and Denmark, all the major markets of the continent are trading at significant discounts to their usual relationship to U.S. market multiples. Notably, Germany, which over the past ten years has traded at an average 17.8% discount to the S&P 500, now trades at a 31.2% discount. There are macro reasons for these discounts, as our regular readers know we are well aware. However, we think that when the potential departure of Britain from the European Union is settled, Europe’s troubles will be medium- and long-term — and in the meantime, if the U.S. market breaks out to new highs, and European growth continues its current recovery, the resultant optimism might create the opportunity for a “reversion to the mean” trade in Europe. For such a trade, we would look particularly at Germany and Ireland. (While Denmark is attractive, it has not gotten as cheap as other European markets.) U.S. investors could approach this theme through a number of ETFs and shares, but we should say that we are not interested in investing in European banks. Investors who wish to invest in Europe should realize that the major European country equity indices’ largest weightings are usually banks and financials. We prefer to stick to select energy, mining, and industrial shares. However, while we are exploring opportunities in Europe, we don’t plan to initiate positions until we have more clarity on the outcome or consequences of the Brexit vote on June 23.
