Why the outlook for European equities is brighter than ever

Many misperceptions still linger about Europe. Despite this, the outlook for European equities is the brightest it has been in over a decade.

Why do we believe this? Firstly, the current stretch of European underperformance is unprecedented both in length and magnitude – with macro data still near two-decade highs. While the corporate earnings recovery continues to come back strongly, the discount to the US remains at a record wide level at 39 per cent – versus a 24 per cent average.

There is a myth Europe always underperforms the US, but the current stretch of underperformance is unprecedented.

Europe and the US have moved in lockstep for decades and the stretch of significant European underperformance since the 2008 financial crisis is highly atypical. However, even if we include the crisis, in dollar terms, European equities outperformed the S&P 500 index in eight out of the last 15 calendar years.

We often hear European earnings are not growing as fast as the rest of the world. This is also no longer true, and the operational leverage of the region remains underappreciated.

The earnings argument is valid, but backward looking. We believe the single biggest reason for Europe’s post-crisis underperformance relative to the US has been the lack of earnings recovery.

Looking ahead, analyst consensus now expects European earnings to grow at a similar rate to the rest of the developed world, at around 10 per cent in 2019. We also see significant upgrade potential to these consensus numbers.

As the US enters its late cycle phase, it is time for more investors to take a closer look at Europe.

Another argument we hear is that Europe always trades at a discount to the US.

While true, the current discount is well above average and close to the widest on record. While we agree that some discount to the US is warranted, we are finding it very hard to explain why Europe is trading close to the deepest historic discount, while earnings are expected to grow at the same pace as the US.

As for talk, the recovery in European economies is running out of steam, the macro data is still near two-decade highs and supportive of robust growth.

While growth is no longer accelerating – the most recent readings of PMIs, retail sales, industrial production, credit growth, unemployment and the European Commission’s broader economic sentiment indicators all point to robust GDP growth for the next 24 months.

Consumer confidence remains at a two-decade high also and we see no reason why the market should not re-rate to a level implied by the consumer’s bullish outlook.

Another myth surrounding Europe is that capital expenditure (capex) remains muted and European chief executives are concerned about the outlook.

The reality is capacity utilisation is nearing peak levels and there is strong pent-up demand from a decade of underinvestment - demand which cannot be met overnight. We think this is only the beginning of a multi-year spending cycle.

As for outflows, they are not a leading indicator of poor performance. Since March we have now seen 18 weeks of consecutive outflows from Europe, totalling more than $50bn. This is the second largest outflow streak on record.

However, outside of the financial crisis in 2008, the five largest streaks of outflows were followed by strong positive returns over the next 12 months.

Italy is another source of tension for investors, with fears it is on the verge of leaving the euro and will cause the collapse of the currency union.

The reality is support for the euro has increased in Italy and we believe the populist shift in the country does not present real systemic risk. In fact, some of the more unorthodox proposals of the government could even offer a much-needed boost to the stagnant Italian economy.

Even though European technology stocks have significantly outperformed the market over the past one, three, five and 10 years, the passive investor has not benefited much from the sector’s returns.

With technology stocks dominating market performance, it is true Europe is structurally underexposed to the space. However, tech has been the biggest contributor to our recent outperformance.

Europe’s Stoxx 600 index has only a 5 per cent exposure to technology, with SAP and ASML accounting for almost half of the index weight.

This highlights a clear flaw in passive investing, which myopically focuses on investing in the largest companies, regardless of quality and growth prospects.

Even though European technology stocks have significantly outperformed the market over the past one, three, five and 10 years, the passive investor has not benefited much from the sector’s returns.

While the current stretch of European underperformance is unprecedented both in length and magnitude, we believe the market is well positioned for an overdue catch-up.

As the US enters its late cycle phase, it is time for more investors to take a closer look at Europe.

Stuart Mitchell is chief investment officer of S W Mitchell Capital