Head - EMEA Investment Strategy
February 22, 2018
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We believe economic and corporate earnings growth combined with investor underexposure more than offset political uncertainty
The recent consolidation in Europe ex-UK equities is another buying opportunity. A strong year is expected, based on the robust GDP growth pickup being reflected in EPS growth, reasonable valuations and ongoing inflows. The challenges posed by political risks, currency strength, and the ECB tapering, need close monitoring. However, at this stage they do not significantly detract from the equity bull case. The strong GDP growth upturn – currently running at an annualised 2.7% - is expected to be at least 2.5% for 2018.
The growth has been notably broadly spread across both manufacturing and services, as well as across countries. As noted by the ECB in its recent statements, easing measures have begun to have a noticeable impact on credit indicators, providing an important positive catalyst. Business confidence is at its highest level for five years and consumer confidence is at its highest level since mid-2000. Coincident indicators, which reflect the current state of the economy, are at the highest levels since 2000.
This economic pickup has led directly to a powerful uplift in average EPS growth, which is expected to be sustained around the mid-teens level in 2018. Valuations are no longer cheap in absolute terms. Ten-year cyclically adjusted priceto-earnings (CAPE) show today’s valuations have moved above one standard deviation above the longer term average.
Therefore, further absolute gains are expected to be in line with earnings growth only. Nevertheless, valuations still look compelling on a relative value basis. European equities are currently 22% cheaper than US equities, and remain 10% cheaper relative to their historic average discount to the US. Furthermore, they offer high average dividend yields of 3.4% as well as a yield premium of 2.5% over European Investment Grade corporate bonds.
The technical backdrop remains strong, with institutional inflows rising from depressed levels. There are two key events on 4th March 2018: the Italian election and the German SPD party referendum. We are expecting the worst cases to be avoided, with Italian and German coalitions likely to be agreed, removing risk factors that could have been holding back inflows from being even stronger recently.
With regard to the adverse impact of the strong Euro on corporate profits, around half of core Europe’s revenues are derived from overseas, but we conclude that the overall impact of the Euro strength is not sufficient to derail the broader equity bull market.
However, we are increasingly likely to see different country, sector and stock impacts. Three summary points to note are: 1. The larger blue chips in core Europe own strong brands and have been showing their pricing power. 2. The pickup in European demand and in global growth are to some extent offsetting the Euro strength. 3. Some companies will benefit from lower import costs. Selectivity across themes and sectors remains key. Our preferred theme is deequitization. This includes companies that are buying back their own stock with surplus cash and thereby boosting their EPS. It also includes companies that might be involved in mergers and acquisitions, which are gathering momentum thanks to the low cost of capital.
Our favoured sectors in Europe remain the cyclicals, specifically financials, energy and technology. Focusing on financials, European banks have improved their balance sheets with recapitalizations and asset sales. Most have now passed the ECB’s stress tests. Margin pressures have eased as the ECB has not reduced the deposit rate from minus 0.4%, while loan growth is now rising amid the firming economic backdrop.
It is likely that 2018 will see rises in fee income and potentially also non-performing loan write-backs later in the year. Thus we are likely only in the middle of a multi-year pickup in returns on equity. The prospective 13% average EPS growth forecast looks attractive with average price-to-book valuations of only 0.85X, while the average EPS growth forecast of 10% for 2019 has upside potential. Historically, bank equity prices have been positively correlated with rising bond yields and we have high conviction that bond yields will keep rising.
The Citi Private Bank Global Investment Committee maintains a neutral allocation in UK large caps, whilst being cautious on mid-cap stocks, which are more exposed to the UK’s domestic slowdown. Large caps in the UK generate approximately 70% of their revenues from overseas and benefit from strong dividend yields in excess of 3.5%.
Unfortunately, Brexit challenges come as economic challenges mount. As the Bank of England Governor Carney’s statements get increasingly cautious, there is weakness in retail sales and the property sector. Sluggish real wage growth and confidence slippage will not be easily turned.
Given this backdrop, heightened equity volatility is likely, with the index range trading at best. We advocate a UK stock picking approach, with emphasis on overseas earners with balance sheet strength and high dividend yields. It is too early to start discounting the post-Brexit environment, which might eventually offer interesting sector opportunities.