Europe looks sexy

For the longest time, no one was really excited about investing in European stock markets.

And why would they? Post financial crisis, the EU went into a prolonged slump, with bouts of bad news like the Greek crisis (and related internecine squabbles), a strong Euro and then Brexit. But perhaps it is time to have a relook.  

A renewed Europe

The EU is now into its fifth year of economic recovery, with unemployment at a nine-year low. The consumer confidence index for the Euro Area increased to -1.2 in September of 2017 from -1.5 in August. It is the highest reading since April 2001 and recent data indicates that the consumer recovery has been joined by a manufacturing one. The manufacturing recovery means higher investment spending and higher levels of employment, which should lead to more consumer spending.

 Germany, the powerhouse of Europe, is seeing a significant pick up of manufacturing activity which picked up by 2.6%, the most in six years, over the month of August. 

But the best news has been from the stock markets. All major national benchmarks in the region are up in 2017. The performance so far this year in USD terms; Greece 9.7%, Ireland 10%, Italy 26% and Spain 24%.

Cheap and expensive markets

CAPE stands for the cyclically adjusted price to earnings ratio. It compares companies’ average annual earnings over 10 years (adjusted for inflation) with their share price.  A low CAPE means cheaper stocks and vice versa.

So, let’s don the cape and fly over Europe in search of good deals.

On a PE basis, the UK looks pretty expensive. However, as per CAPE the UK is relatively cheap, with a score of 15.6, compared to 28.5 for the US. The larger PE is because UK company earnings have been temporarily depressed by the fall in oil and commodity prices in 2015 and 2016 and also historic legal costs faced by banks. However, there is an expectation of a "very large" rise in FTSE 100 earnings over the next 12 months (Bloomberg estimate of 84pc) and share prices could rise significantly, all else being the same.

Italy and Spain look interesting with CAPE scores of 15.4 and 13.8 respectively. This valuation implies around a 50pc return over the next five years [if Cape scores return to historic norms].

 If you are really feeling lucky, look slightly East, at Putin’s playground. Russia is by far the cheapest market, with a CAPE value of 5, thanks to low oil prices and international sanctions. But Russia comes with great risk. it is highly volatile, with FTSE’s Russia index up 89% in 2016 and down 12% so far this year. Plus the market is dominated by cheap state-owned banks and energy companies, so you are making a bet on the oil price and the…ahem….goodwill of the Russian government.

Overall, euro-area stocks remain cheap versus U.S. peers. The Eurozone’s current CAPE ratio of 15.6x is below its own long-term average of 19.9x.

Where to invest

Banking is surprisingly one of the most attractive sectors. There are several reasons for this allure. Firstly, most banks’ profits come largely from domestic Europe, where demand is improving. Also, these lenders have come a long way to address stability issues; the ECB released its stress test results and said that interest rate risk is well managed in most European banks. Finally, monetary tightening with attendant higher interest rates is likely to support the banking sector by boosting net interest margins.

There are also opportunities in consumer discretionary, building material and construction, industrials, health care services and IT, given that some companies within these sectors are also largely exposed to domestic Europe.

Red flags

But before you take out your chequebook, watch out for some key risks that can derail markets and forecasts. And there are quite a few.

Political turmoil in Spain is the latest. A continued stand off or worse, a sudden declaration of Catalonian independence, is negative for markets.

UK’s messy Brexit negotiations is another hurdle. If UK is denied preferential access to EU markets, increased prices for UK exports could make EU consumers switch to domestically produced goods instead. It’s estimated that a “hard Brexit” will mean a USD $22.7 billion fall in annual export revenues across key UK manufacturing sectors.

The ECB is expected to start winding down its massive stimulus early next year. Interest rates may rise and this can damage dividend paying and heavily-indebted sectors such as utilities and telecoms

And the Euro is a critical factor. So many large EU companies are dependent on exports and would love to see the Euro depreciate. But the Euro has been stubbornly appreciating; it’s been estimated that every 10 percent swing in the euro has a direct and indirect impact on European earnings of 3 percent to 6 percent.

Yes there are risks. But as a wag once said. If you don’t speculate you simply can’t accumulate. And Europe looks like a good place to accumulate.