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Europe – basket case or treasure trove?


Markets abhor uncertainty, so it should come as no surprise that international investors are luke warm on Europe. Concerns over international trade, the mounting fracas between the US and China, rising populist movements in France, Italy, Austria, and Poland and the uncertainty of Brexit provide ample reasons to give the continent a wide berth. However, out of disdain and neglect opportunity can emerge. This is something we are hearing more and more from our selected European active managers.

Regardless of the outcome of Brexit negotiations, 2019 is a year of notable change for Europe. There will be new presidencies for the European Commission and European Council and critically the European Central Bank as well. How this will play out is too difficult to predict so investors are beginning to assume the worst. Valuations are reflecting a gloomier mood. Europe is trading on a price/earnings multiple of 14, representing a 17% discount to the US. Assuming modest – that is single digit – earnings growth for 2019, for medium and long term investors, much of the negativity seems factored in.

The end of Mario Draghi’s eight year term at the helm of the ECB comes in October 2019 and investors don’t seem to be placing as much emphasis on it as perhaps they should. His persistent, stimulative policies have given a huge lift to both the EU economy and to European equity markets. His ‘do whatever it takes’ approach led to a €2.5trn expansion in the ECB balance sheet which helped to stabilise the European financial system and drove equity markets higher. This positive correlation can be seen in the chart below. It shows the percentage change in EuroStoxx50 having allowed for an 18 month lag following changes in ECB balance sheet. What stands out is that following the peak in the ECB asset purchase programme in 2016, when this was running at a monthly rate of €80bn, the subsequent contraction in the rate of growth of the ECB balance sheet is now feeding through into European stock markets.

ECB Total Assets vs. EuroStoxx50 (18M Lag) – Yearly Change

Source: Reuters Eikon

Source: Reuters Eikon

The inevitable question is: what happens next? If the planned unwinding of QE continues, market liquidity will continue to tighten and this will be a headwind to capital markets. If inflation remains subdued, which is the consensus view because of excess economic capacity, then the market’s expectation of a first interest rate hike by the ECB in the summer 2019 suggests a continuation of the broadly supportive policy environment we have grown used to. As the USA pursues its monetary tightening, Europe could begin to look increasingly interesting.

But this hinges on who takes over at the ECB. They will determine the policies adopted by the central bank. Of the four primary candidates, only Jens Weidman of the Bundesbank is keen to unwind QE. By contrast the others, Erkki Liikanen of Finland, Francois Villeroy de Galhau of France and Philip Lane of Ireland, appear far more pragmatic and data sensitive, and therefore perceived to be market friendly.

So in summary, given the political posturing throughout 2019 as the European political calendar rolls forward, markets can be expected to remain bumpy. We see an opportunity here for long term investors to buy into globally competitive, European companies at attractive valuations. By drawing on the expertise and discipline of our selected European managers we expect to deliver favourable risk adjusted returns in this asset class regardless of the political, fiscal and monetary backdrop. As always with investing, you have to take risk to earn a return. Only the politicians can muck it up.


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