The outlook for European equities beyond its ‘golden year’

Following what has been a golden year for European equities, the outlook for the region is looking more uncertain. James Rutherford, co-head of investments for European equities at Hermes Investment Management, discusses how he is capitalising on market conditions and where he is finding opportunities.

The outlook for European equities beyond its ‘golden year’

European equities have enjoyed a perfect storm of positivity this year. Reduced political uncertainty, improving economic data and steady company results have all driven investors back to this often-overlooked region.

However these benign conditions cannot last forever and several headwinds are rising. Some parts of the market are already experiencing the fickle nature of some of those that have followed the herd. But, while there is uncertainty as to the direction of markets going forward, the indiscriminate behaviour of markets means there are opportunities for investors in Europe.

A new leaf?

The year so far has been a very healthy one for equity investors, even in the context of the run experienced since the financial crisis. Global GDP growth has finally synchronised across almost all regions and is also rising, lending significant support to markets. The European equity market has particularly benefited, attracting high levels of external investment.

The underlying economic data in Europe has been notably strong this year. Companies are consistently meeting earnings growth expectations, while the eurozone is experiencing sustained growth, with the GDP annual growth rate now at 2.3%[1], its highest level since 2011. Supported by these positive trends, investment into the eurozone has reached pre-crisis levels for the first time since 2008.

Also supportive is the broader macroeconomic environment. Over the past few years, the fragility of the eurozone in a political context has dominated sentiment on the region. However, recent election results have calmed this anxiety and have helped fuel the rise in investment into the region.

Bumps in the road

While much of the recent data has been positive, the European markets are still exposed to a number of headwinds. Most pressing of these has been the strength of the euro in 2017, which has had an impact on the region’s vital export market. This currency strength has been driven largely by sentiment rather than economic realities, leaving it exposed to rapid reversals.

The strength of the currency, and the unusual popularity of the European market, has also had an impact on buying patterns with narrowing breadth in the market. Investors have focused on more domestic sectors such as financials and utilities, which are not the growth-type areas that have proved popular in other markets.

Meanwhile much of the good news during results season failed to prompt a market response, contrasting sharply with results misses, which were excessively punished. This kind of behaviour reflects the momentum-driven investment style that follows on from a rapid increase in investment into a market and reflects the short-termism of some investors.

Also problematic is the broader data surrounding the market, which in many cases is historically anomalous. Most notably both volatility, as measured by the VIX index, and interest rates remain at historic lows – a position that cannot be maintained forever.

Overlooked opportunities

Although the short-termism demonstrated by the some of the market this year is challenging, it has also provided an opportunity for long-term investors to buy companies with strong fundamentals at attractive prices. Most notably, some stocks have been excessively punished for negative results when the issues being reported are short term and rectifiable. In other parts of the market, overriding sentiment has tarnished whole sectors unnecessarily.

One sector that has been overlooked in particular is pharmaceuticals. It has been affected by ongoing sentiment from last year surrounding the impact of Trump’s proposed, and now failed, abolition of Obamacare. This negative sentiment was aggravated by the strength of the euro as the sector is export led. Pricing issues in the US have also taken their toll.

Seeing through the sentiment

While Europe has experienced a strong run of support this year, the market has not been particularly discriminatory when it comes to valuing businesses, driven instead by sentiment and momentum. Meanwhile, changing monetary policy and the historic habits of the European market suggests that the broad-based positivity currently being experienced will not last into the long term.

By looking beyond short-term factors to company fundamentals, investors can still find attractively-valued opportunities in Europe that will remain compelling in the longer term, even when the current golden period comes to an end.

[1] Source: Bloomberg

 

Please remember, no news or research item is a recommendation or advice to buy. Every Investor is not responsible for accuracy and may not share the author’s views. If you are unsure of the suitability of any investment for your circumstances please contact an adviser. All investments can fall as well as rise in value so you could get back less than you invest and tax policies may change.

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