By: Dylan Ball, ACA Executive Vice President, Head of European Equity Strategies Templeton Global Equity Group®
The Late-Cycle Market
We expect the trends that have led US equities to outperform their European counterparts in recent years to begin to reverse. Years of ultra-low interest rates and central bank bond buying distorted markets by favoring stocks with high growth expectations and punishing those with lower growth outlooks. Big technology stocks in the United States have been one of the major beneficiaries of this trend in recent years. Moreover, passive investing has reinforced the trend by channeling money into market leaders and out of stocks that are declining. This process is divorced from price discovery and valuation and more tied to momentum and trend following, in our assessment.
We believe these trends are coming to an end as US interest rates rise and central banks begin to pare back their extraordinary stimulus measures. As liquidity continues to be withdrawn, markets should once again focus on earnings and valuations. With US earnings growth unlikely to keep up its recent pace in 2019, robust European corporate earnings growth may begin to garner greater attention.
Unlike the United States, European markets are comprised of a larger number of companies whose earnings are sensitive to interest rates and price increases, such as banks and commodities producers. Modest increases in interest rates could have a positive impact on bank earnings, for instance, while oil companies are beginning to see the benefits of higher crude oil prices flow through to their bottom lines. Robust metals prices could also potentially provide support to European mining firms and the various companies that supply them with equipment and services.
Furthermore, valuations in Europe have remained much more attractive to us than those in the United States. Regional companies have been trading at historic valuation discounts to their US peers. Europe’s trailing price-to-earnings multiple, for instance, has halved in just the past two years. This has come despite double-digit earnings-per-share increases.
Political Risks Look Manageable
We believe perceived political risks coming from trade tensions, Brexit and Italy are partly to blame for Europe’s underperformance. But in the end, we expect each to be resolved without major disruption to global and European financial markets.
Pragmatism should eventually win out in the United States’ trade dispute with China, in our view. While the two sides appear far apart, we believe the Trump administration will eventually make a deal. Resolving this issue is important for European companies as they are major exporters to both the United States and Asia.
While we have seen a recent breakthrough between the United Kingdom (UK) and European Union (EU) on the framework for a Brexit deal, we believe uncertainty is likely to persist. As a result, we remain cautious on the UK market, particularly domestically focused companies. We view the market during this ongoing Brexit process as a “special situation” offering potential opportunities for investors with the right approach, risk tolerance and time horizon.
Italy is potentially a bit thornier, particularly given the recent budget negotiations between Italy’s populist government and the EU. Italy’s proposed increase in deficit spending to help stimulate growth has brought it into violation of some of the EU’s budget rules.
Despite recent rhetoric, we do not see the potential for a break between Italy and Brussels. We believe that based on recent polling most Italians favor staying within the currency bloc. And we see little economic rationale for a split. Quite the opposite. Italy enjoys a current account surplus as well as a trade surplus thanks to strong export growth from the country’s dominant northern manufacturing sector, suggesting there is scant need for competitive currency devaluation. Additionally, Italy’s membership in the eurozone has helped keep borrowing costs much lower than they would be if Italy were outside the group. Italian politics may continue to be messy, but should not result in a significant political crisis for Europe, in our assessment.
Once investors get past the political noise and uncertainty, and as the cycle matures, we believe fundamentals will matter again. And given what we view as Europe’s attractive earnings growth and market valuations relative to other regions, we see the potential for a bounce in the coming year.