Pundits have favored European equities this year (for instance). Valuations relative to American equities had a lot to do with this. So did a belief that, after a long, slow and dismal recovery from the crash and the European debt crisis, European economies were recovering. But on the face of it, European equities have not offered much competition to the 11.5% gain that the Standard & Poor’s 500 Index has posted year to date through September 25.
Of the markets shown above, which account for the overwhelming majority of European market capitalization, only Poland and Italy have performed better than the S&P, although Switzerland (somewhat surprisingly) has come within a few tenths of a percent of matching its performance. Unfortunately, these are unlikely to be the principle target markets for U.S. investors in Europe.
However, international investment is a matter of risking – and perhaps benefitting from – currency exposure as well as the exposure to the underlying equities. Most analysts regard currency gains as low quality and insecure profits, but investors who have enjoyed them are unlikely to object to such windfalls. Dollar-based investors in Europe have benefited from the 12.7% appreciation of the Euro, the 9.1% appreciation of Sterling, the 5.4% appreciation of the Swiss Franc and the 15.9% appreciation of the zloty, although they have been penalized by depreciation of the Swedish Krona. With only that latter exception, in dollar terms European equities’ returns look much healthier:
The strength of the Euro is largely driven by anticipation that the European Central Bank will change to a more neutral monetary policy from the very strongly stimulative policy it has pursued since the Crash. The Euro’s reaction to this has put the ECB in a quandary. In a European context, where exports are a substantially greater portion of national output than they are for the U.S., the effect of currency strength on competitiveness and thus production is felt rapidly and strongly.
Europe is a significant importer of commodities, so that currency strength tends to depress producer price inflation. Yet most European exports – from wine to machine tools − are many value-added steps above the commodities of which they are composed, so the benefit of lower commodity prices on European competitiveness is muted. Currency’s effect on consumer prices is less straightforward, since European retail prices tend to react sluggishly if at all to commodity price declines.
Active managers, believing that despite Euro strength, Europe’s economic outlook is sound and valuations compelling regardless of currency conditions, have responded by shifting exposure from exporters to companies that sell most if not all of their production within the Eurozone. Since exporters and multinationals play a fairly dominant role in European equity indices, this transition accounts for the softness that most European indices (in local currency terms) exhibited from May through August, and their recovery since then, as leadership has shifted toward domestically-oriented issues.
However, the latest Eurozone Purchasing Managers’ Index indicates anything other than a currency-induced slowdown. Manufacturing – precisely the export-oriented portion of European economies that would be expected to suffer from currency strength – has reached its highest level in 6½ years. Europeans obviously have reason to be confident that their international competitive position is not unduly hampered by currency strength.
Some of this confidence comes from the knowledge that the strength of U.S. domestic demand is sufficient to absorb most U.S. capacity. This was typical of global economic cycles prior to the 1990s. U.S. productive capacity did not leave a great deal of excess production for export if the economy was sufficiently healthy, leaving the field open to European exporters to meet the needs of the rest of the world (although the U.S. continued to maintain strong market shares in Latin America).
Confidence is also bolstered by the breadth of Europe’s export revival: unlike recent periods, where demand was so completely dominated by China that Europeans could not help but be concerned about its continuation, demand is currently very broadly based, both geographically and by product category. Most importantly, that includes European domestic demand – often, in the past, a drag on European performance. All the largest Eurozone economies as well as Britain are reporting very solid household consumption data, and investment both by governments and business is rising.
Europe has also received some stimulus from others’ misfortunes. Petrochemical manufacturers – the main European cluster is in Rotterdam − are benefitting from storm damage to the Houston refining and chemical complex, both by filling in gaps in U.S. supplies as well as serving traditional U.S. export markets for these products (especially Latin America). But given Europeans’ fundamental competitive disadvantages in this manufacturing category, they are unlikely to retain any market share they capture for very long. However, they will enjoy higher prices as well as a temporary increase in share. This is doubtless true for other European manufacturers as well.
Europe is not without its fragilities: unemployment, especially youth unemployment, remains disturbingly high in many countries, particularly Spain. Some banking systems, notably in Italy, remain under-capitalized relative to their exposure to dubious borrowers. Greece is not really significantly closer to economic health than it was five years ago, and remains a sword of Damocles over all European banks. Russia is a military threat as well as an economic one, thanks to its dominance over West European natural gas supplies. Populations are still aging, immigration continues to create more problems than the demographic problem it supposedly solves and Mohammedan terrorist groups will still find Europe an easy target for their activities. Separatist tendencies persist, from Scotland to Catalonia and Flanders to Northern Italy, and there are growing strains in the relationship of Eastern European countries with the European Union core. The withdrawal of Britain from the European Union is likely to cloud predictions about the outlook for all concerned for years to come.
However, other than Brexit and, to some extent, Eastern European self-assertion, all of these issues are perennials: pretty much the same could have been said on each of these topics three or even ten years ago. Reaction to the election of allegedly free-market-oriented Emmanuel Macron in France has almost certainly been excessively optimistic, and the re-election of Angela Merkel was neither unexpected nor obviously favorable to a resolution of the many policy challenges facing not only Germany but also the European Union. However, there is a glimmer of hope that inclusion of the Free Democratic Party in her coalition could lead to larger tax cuts than she has suggested, which would tend further to bolster German consumption, to the benefit of all of Europe.
European equities face a wall of worry, but given strength in domestic consumption, one that is less daunting than they have faced since the 1980s. Plenty of things can go wrong, not least continued currency appreciation. European shares tend to react far more strongly than U.S. equities to military/political crises such as the one that seems to be brewing in North Korea, and any of the laundry list above of things that could go wrong – most notably in Greece – could undermine European confidence quickly and dramatically.
However, Europe seems to have hit a sweet spot that it may, with luck, not be dislodged from soon. The pundits were right: European investment was attractive at the beginning of 2017, and it remains attractive today. Valuations in comparison to U.S. equities remain compelling, and the growth outlook has only improved since the beginning of the year. It is likely that the contributors to returns will shift away from currency appreciation to fundamentals such as earnings, and this is all to the good. European companies’ profitability can withstand only so much currency strength, and the major European exporters and multinationals have yet to contribute as strongly to European share price performance as they potentially can.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.