Europe's rally has a way to go yet

Charles Younes

Charles Younes

Despite the uncertainty around the elections in the Netherlands and France, European equities have started the year on a strong footing. In the year to date to the end of June, the FTSE World Europe ex UK index has gained 13 per cent for a UK-domiciled investor.

European equities outperformed other developed market equities – such as US equities (the S&P 500 index is up 3.7 per cent) and Japanese equities (the Topix has risen 6 per cent) – over the same period. They also performed in line with emerging market equities, which increased 12.7 per cent. The drivers of this performance are multiple, but the political landscape remains the most dominant one.

Investors have avoided European equities in recent years as the fear of a eurozone break-up was tangible. This was once again the case in 2017 as investors were worried about the triumph of populist leaders in the Netherlands and France, leading to a ‘Frexit’. But French voters stayed away from this populist revolution and backed the social-liberal candidate Emmanuel Macron.

The European Central Bank’s (ECB) monetary policy has also been driving performance of European equities. Contrary to the US Federal Reserve, the ECB has maintained its negative interest rate and quantitative easing policies.

Manufacturing and services PMIs have also accelerated sharply this year, with figures at a post-crisis high, suggesting a rise in consumption-driven demand. Finally, the euro still trades at low levels, driving the more export-orientated European economy. Using different valuation models, the currency remains below its fair-price level.

Past performance is not a guide of future performance, and I am far from believing that European equities can gain another 13 per cent in the next four months. This is especially the case as the markets are becoming more efficient in repricing the news.

Even worse, markets have bought the rumour and sold the news this year: for example, using a trading strategy to buy on the day of the actual election would have been expensive. So far this year, equity investors have lost money by buying Dutch or French equities relative to other European equities following the respective elections in those two countries.

A similar pattern could be seen in the sovereign bond markets. The spread between French and German government bond yields had narrowed several days before the election day, having widened significantly at the beginning of the year.

Bearing in mind that the odds of Angela Merkel winning the 2017 German elections are close to 85 per cent, it would be fair to say that the market has already repriced the political risk linked to the elections in Europe this year.

So what could be the catalysts for improving performance this year? Despite the political boost already being priced in, two other drivers remain in place: easing monetary policy and euro weakness.

Although there have been talks about the ECB’s eventual exit from quantitative easing, we are still far from reaching a consensus among members of the executive board. Any news that the central bank might delay this exit could further help European equities as we are now aware of the impact of mass bond buying on security prices.