Goldman
Strategy Espresso : Flows: Better growth drives demand for European stocks by both US and European investors
The latest US TIC data for December 2014 shows a small net outflow from European equities of USD 2.0bn; this comes after positive flows in both November and October. The 3-month average buying is still on a rising trend, at USD +5.3bn per month; we think the 3-month average is a better gauge of flows, given the volatility in the monthly data. We had seen sharp outflows by US investors in the late summer/early autumn; these outflows coincided with much weaker European economic data but, in the last three months of the year, flows have been more positive.
The US treasury data is collated on a custodial basis and may reflect flows held in Europe or going through Europe that don't pertain to domestic European equities. We therefore need to be cautious when interpreting the data. We also monitor the AMG/Lipper data, which comes from mutual funds and is timelier and higher frequency than the TIC data (but the universe is far smaller). This shows a sharp spike in flows by US-based investors into European equities, starting towards the end of January, which coincided both with the ECB QE announcement and a pick-up in the European economic data. Indeed, the last 4-weeks have seen the strongest inflows by US mutual funds into European equities since June last year. The chart below shows the sharp spike upwards since the beginning of the year - although the rise in inflows is small compared to the flows in 2013 and early 2014.
European investors are also swinging into equities. Aggregated Flows data from individual European equity funds (via Bloomberg) shows a sharp tick-up in flows in January, after being weak in the latter half of last year. Chris Turner also highlighted this turn in fund flows in European Flow Monitor: QE boosts demand for European assets; equity funds see inflows, February 2, 2015.
Have the fund flows been excessive versus the data? No, the flows have picked up with the improvement in the economic data and in our view remain relatively modest (see chart). For US funds, we highlighted in the previous month that the relative moves in the US and European PMIs were starting to favour Europe. This move in the PMIs has been strongly correlated with the flows into Europe. The level of economic growth still favours the US but the delta favours Europe; by 4Q15, we expect sequential qoq annualised growth of 2.2% for the Euro area versus 1.2% in 1Q15, whereas the US is expanding at 3.0% pace throughout the year on our forecasts. We discussed the relative improvement in economic and earnings data for Europe in Strategy Espresso: Europe to continue outperforming the US, February 12, 2015.
Where is positioning now, in our view? US investors were very under-positioned in European equities in 2012, so, when growth improved and risks diminished in 2013, there was a need for positioning to 'catch up' with the data improvement and Europe enjoyed a sharp uptick in flows into equities by US investors. We track the buying of US investors cumulatively over time and compare this to the trend of buying seen since the late 1970s. The rise in buying from 2013 through to early 2014 lifted cumulative investment into European equities above its long-run trend (see chart below). The net outflows since the summer of last year took them back to around the trend investment line, now they are hovering just below. We see this as just a rough approximation of positioning and, while we no longer see US investors as under-positioned in European equities as they were in 2012 or 2013, we similarly don't regard positioning as aggressive in European equites, despite the recent inflows.
What drives the flows from here? For US investors, we've found that they have historically been most sensitive to changes in the pace of growth and to risks, and not so sensitive to valuation. So, the fact that the European market has risen as earnings estimates have moved downwards, pushing up the forward P/E to above 15x - a 10-year high - , is not in our view an obstacle to flows from US-based investors. The correlation between US monthly flows into European equities since 2002 and the change in the ERP has been -43% (so higher ERP means lower flows), with the change in the Euro area manufacturing PMI it's been +39% (higher growth sentiment, higher flows) but, with 12m forward consensus P/E at the outset, the correlation is zero. We continue to argue therefore that economic improvement and continued contraction of the ERP are synonymous with continued flows from US investors. We see a spike in the risk premium as the main risk to flows, potentially triggered by, say, an exit of Greece from the EMU or by further escalation of the conflict in Ukraine.
Are we seeing a switch from bonds into equities? Historically, US flows into both European equities and European bonds have been correlated - so US investors are either buying or selling European assets and some goes into equities and some to bonds. But more recently we find that US investor flows into European bonds were negative through the end of last year whereas there is a clear jump upwards in equities, in our view, reflecting both the stretched valuation of European bonds and the greater gearing to a growth improvement available in equities.