Is renewed confidence in European equities justified?

Figures from the European Fund and Asset Management Association (Efama) show that while net inflows into both equity and bond funds (institutional and retail) fell slightly in the second quarter of 2013, the combined net assets of European Ucits and non-Ucits funds have increased by 3.2 per cent since the end of 2012 to €6,500bn (£5,500bn).

In addition, net inflows into Ucits funds for the first six months of 2013 increased by €46bn year on year to reach €144bn, driven primarily by net sales of bond funds at €74bn. Balanced funds accounted for €64bn and equity funds lagged behind with net sales of just €36bn.

Data from Morningstar’s latest European asset flows report on open-ended retail funds, suggest equity funds are the more popular vehicle for European investors, recording €10.2bn of net new money.

Ali Masarwah, a member of Morningstar’s European fund flows team, notes: “Although flows into fixed-income funds recovered somewhat, last month’s inflows of €5.47bn were a far cry from the huge demand for bond funds over the previous 18 months.

“Last month in particular, diversified bond funds and Euro government bond funds fell out of favour, while high-yield and short-term bonds carried the day. Arguably this reflects investors´ preference for the less interest rate sensitive credit and shorter-duration investments in times of rising interest rates.”

This trend towards European equities is highlighted by Russell Investments, which notes the better economic situation in the region could mean European equities provide better value than other non-US developed markets, particularly for dynamic and deep-value orientated investors.

Wouter Sturkenboom, investment strategist for Russell Investments Europe, says: “We are seeing a somewhat friendlier environment for European equities in recent months as the eurozone emerges from recession. And this has attracted some investors interested in taking on riskier companies and deeper value plays.”

The elephant in the room

Despite the renascent optimism and strong evidence of positive investor sentiment, Mr Sturkenboom urges caution and points to the elephant in the room in Europe: the continuing uncertainty over troubled peripheral European economies.

“However, investors should be mindful that many questions remain in Europe in the coming months, such as potential financial bailouts for Greece and Portugal, political uncertainty in Spain and Italy and the coming German elections.”

Greece has remained quiet of late, however there has been recent speculation that the country could require a further bailout once its current programme runs out.

Earlier this month Jeroen Dijsselbloem, president of the Eurogroup – the informal body consisting of the finance ministers of countries in the euro – informed the European Parliament’s Economic and Monetary Affairs Committee that it would be “realistic to assume that additional support will be required for Greece beyond the programme”.

Although he welcomed the progress made by the Greek authorities to restore fiscal sustainability and to implement structural reforms to increase competitiveness, he highlighted that further progress was needed. Details of any further measures are uncertain, but could include a further reduction to the interest rates on the Greek loan facility.

In its latest interim economic assessment the Organisation for Economic Co-operation and Development notes the ‘encouraging’ gradual pick-up in momentum in developed economies including the eurozone’s emergence from recession.

But Jorgen Elmeskov, deputy chief economist at the OECD, notes: “The euro area is still vulnerable to renewed financial markets, banking and sovereign debt tensions. High levels of debt in some emerging markets have increased their vulnerability to financial shocks. And a renewal of brinksmanship over fiscal policy in the US could weaken confidence and trigger new episodes of financial turmoil.”

In particular the OECD warns supportive monetary conditions in the euro area “must be maintained” as rebalancing in the region remains incomplete with weak domestic demand in high debt countries having been offset by stronger exports to a limited extent.

The report states: “Reforms to enhance productivity, such as easing restrictions in product markets and making labour markets more dynamic, will help to improve underlying competitiveness and export performance. At the same time, measures to create more favourable conditions for investment in the surplus economies would help to achieve more balanced growth in the euro area as a whole.”

US influence

Frances Hudson, investment director and global thematic strategist at Standard Life Investments, adds another key driver for the markets, not least European markets, is when and if the US Federal Reserve starts tapering its quantitative easing programme.

“This is partly because it removes policy options from the ECB, because it would be less helpful to be seen to be moving in the opposite direction [to the US]. That seems to be more of a market driver than some of the other things.”

She adds that signs of stabilisation in the eurozone economy have coincided with emerging markets falling out of favour with investors.

“Europe is now regarded as being more attractive and more people have woken up to the fact that just because your company is domiciled in one particular place that doesn’t mean that determines the outcome for your business.

“I think there is now more discrimination in the market, people are paying more attention to company fundamentals or industry fundamentals when it comes to selecting their investments, so the environment has changed a bit.”

Rob Burnett, investment director and head of European equities at Neptune, adds that on the back of improving financial conditions and increased availability of credit, the European economy could be set to recover sharply, with GDP in 2014 potentially greater than 2 per cent.

He states: “What has been striking, however, is that in spite of these improved conditions the economy has still been weak. This weak growth can largely be explained by current fiscal policies, which have dragged GDP down between 1 and 1.5 per cent every year for the last three years.

“Critically, all of the EU governments have outlined their fiscal positions for 2014 and there is no meaningful austerity planned. Our opinion is that austerity is ending at the correct time: Europe has completed sufficient government spending cuts to move towards surpluses on a cyclically-adjusted basis and therefore there is little need for further tightening. The outcome of an end to austerity could be a near 1 per cent uplift in GDP in 2014.”

With improving economic data driving investor confidence and seemingly co-ordinated action by central bankers around the globe to boost growth, the unloved and sometimes undervalued area of European equities might be about to step into the spotlight once again.