European Equities: The Burden of Hope
There are good reasons to invest in European equities—the problem is that everyone agrees about them
European stocks have offered investors euphoria and despair in 2015, and are ending the year with modest gains. Many are still betting that Europe can perform in 2016. That in itself is a problem.
This year has offered a wild ride. The Stoxx Europe 600 rose a dizzying 20.9% by mid-April, only to crash back to earth in August as investors panicked over China and deflation; stocks then regained their poise but have been pummeled by disappointment over European Central Bank policy and a renewed rout in commodities. The index is now up 7.3% for the year, far off its peaks; the weakness of the euro means it is down in dollar terms.
But hope springs eternal. Relative to other parts of the globe, the European economic picture still looks supportive. Growth has held up in the face of global headwinds; leading indicators point to continued expansion. Unemployment is falling, low oil prices should boost consumers and fiscal policy has ceased to be a drag. The ECB, despite December’s failure to match market expectations, is still loosening monetary policy, and interest rates are remarkably low while lending is picking up. The backdrop is supportive.
Meanwhile, the performance in 2015 suggests that caution has prevailed in European equities: the winners have been defensive sectors like food and beverage. Yield is still a big focus for investors given the negligible returns available on government and high-grade corporate bonds. Equity investors have been behaving more like bond investors in terms of risk appetite. Relief in commodities, an easing of emerging-market fears, or stronger eurozone growth could all give European markets a boost.
As a result, European equities, along with Japanese stocks, are a common choice as a better bet than their peers in 2016. But that consensus view poses a challenge: if everyone already likes European stocks, it is difficult to see how they can perform. Popular trades are vulnerable to disappointment.
The external risks are clearly large and hard to predict: commodities and China look like wild cards. There are disturbing rumblings in the U.S. credit market, where high-yield bonds are in trouble. But homegrown problems remain too. European earnings have once again failed to pick up in aggregate, although the meltdown in commodities is largely to blame. But with the Stoxx Europe 600 already trading on about 15 times the next 12 months’ earnings, according to FactSet, earnings need to rise. Expectations for next year are moderate, with growth of 7-8% forecast.
The eurozone successfully coped with the renewed threat of a Greek exit in 2015 but political risk isn’t abating: the refugee crisis could ultimately be a much harder problem for Europe to deal with, although so far it has had little market impact.
The base case for European equities is still strong enough for investors to keep the faith. But it isn’t as compelling as it was a year ago. Being popular isn’t enough to guarantee success.