Stocks: Three reasons Euro area stocks are compelling

By Steve Brice

The volatility in recent months shattered the relative calm that had prevailed in global financial markets for nearly four years. Almost all major equity markets corrected more than 10 per cent during the summer and many emerging markets entered a bear market. October’s rebound came as welcome relief, helping make up most of the earlier losses in the US while recouping some of the draw downs elsewhere. What to expect from here?

To allay the biggest fear first, we do not believe the recent volatility was a precursor to a prolonged bear market in the developed economies. Typically, bear markets come with recessions and there are no signs of a recession unfolding in the US or Europe in the next 12 months.

Meanwhile, low inflation due to falling commodity prices means monetary policy in developed markets is likely to remain highly accommodative well into next year and, possibly, beyond.

Against this backdrop, we believe the Euro area stands out as a destination for equity investments – and for three reasons:

1) Earnings growth in the Euro area is expected to far exceed those in the US and UK, backed by improving margins which are getting a boost from rock-bottom raw material and borrowing costs. Meanwhile, the weak euro is boosting exporters, supporting revenues

2) The smaller share of commodity companies in the Euro area makes the region relatively attractive, given the bearish outlook for energy and materials

3) Euro area equity valuations are cheaper than those in the US

Let’s look at these in some more detail.

Earnings growth in the Euro area

Earnings growth at Euro area companies is forecast to grow about 12 per cent in the next 12 months. That’s faster than the 7 per cent growth expected in the US and 2 per cent in the UK. The main driver is falling raw material and borrowing costs which is helping boost corporate profit margins.

The European Central Bank (ECB) has forced down borrowing costs to record low levels. Lower input and borrowing costs have helped corporate profit margins recover from 2008 lows. While Euro area margins remain below 10 per cent recorded in the US, they are expected to expand further – whereas US margins may have peaked.

Meanwhile, the ECB’s accommodative monetary policy has helped weaken the euro almost 30 per cent against the US dollar since the financial crisis. This is a windfall for Euro area exporters, particularly in the industrials and consumer sectors, as it gives them a competitive edge against other exporting economies. Today, almost 55 per cent of the Euro area’s corporate revenues come from outside the region.

Smaller share of commodity companies

In our view, euro area stocks are appealing, especially against the UK, due to their relatively lower exposure to falling commodity prices. Energy and materials sectors account for only 13 per cent of the stocks in the Euro area’s stock index, compared with 20 per cent in the UK.
In the US, the share of the commodity sector in the benchmark S&P500 index is 11 per cent. As a result, Euro area corporate profits are likely to face less of a drag from continued declines in oil and metal prices.

Equity valuations are cheaper

Equity valuations in the Euro area are cheaper than those in the US and UK, despite the region’s companies reporting faster earnings growth. This is an anomaly which is likely to be corrected, especially as the strong US dollar continues to weigh on US corporate earnings.

The improvement in Euro area margins is also supportive of higher valuations. Dividend payout ratios have declined in recent years, largely because of reduced payouts from financial sector companies. We expect the trend to reverse as banks recover from the euro crisis of the past few years which, in turn, should boost Euro area stocks.

Robust against risks

With the Greek crisis tackled, the main risks to the outlook for Euro area equities come from outside the region. The high exposure of the region’s companies to the US and emerging markets means any slowdown in the global economy is likely to affect corporate earnings. However, the region is more exposed to the US and UK – among the more robust of the world’s economies today – than to other parts of the global economy. This should provide resilience to Euro area corporate earnings. We do not expect the recent terrorist attacks in Paris to materially affect consumer sentiment.

A reversal in the euro and tightening of monetary conditions are other risks. However, these risks are likely to surface late in 2016 or later, especially with the ECB preparing to ease monetary policy further. Until then Euro area stocks are likely to provide among the best returns globally.

(Steve Brice is Chief Investment Strategist at Standard Chartered Bank’s Wealth Management unit.)