As the summer has come to a final close, there is increasing evidence of economic recovery in the eurozone.
The second quarter finally showed positive GDP growth after a record run of six negative quarters. Purchasing manager indices have risen above the neutral 50 level across most of the eurozone, and suggest a broadening and strengthening of the recovery in the second half of 2013.
The improvement has mostly been driven by looser monetary conditions in the wake of Mario Draghi’s ‘whatever it takes’ speech in July 2012 and the introduction of the European Central Bank’s Outright Monetary Transactions programme. This removed the risk of eurozone breakup. A gradual restoration of competitiveness in the periphery has also played its part.
But, lest we get carried away, a return to strong rates of growth is unlikely at least until the structural problems in household and bank balance sheets are worked off.
Nevertheless, a return to growth should boost the performance of European equities in coming quarters, and perhaps we saw the first signs of this in Europe’s relatively robust performance in August. This could challenge stale bearish views on Europe, and force many investors out of longstanding underweight positions in European equities.
The scale of European equity underperformance for the past six years makes clear the potential for a performance catch-up. The case is perhaps strongest versus the US, where the performance and valuation deltas are largest: since early 2007, the MSCI Europe ex UK index has underperformed the MSCI World index by some 25 per cent, and the MSCI USA index by nearly 40 per cent (local currencies).
There has been some disagreement among commentators as to where the long run of weak performance has left European equity valuations. But this is largely due to the fact that European earnings have suffered during the recession and are at depressed levels, hurting valuation metrics based on current earnings.
Therefore on a current trailing price to earnings ratio (p/e) of 16.3x, Europe ex UK does not look particularly cheap compared with the US at 16.7x. But using a cyclically adjusted p/e on the basis of a 10-year moving average of earnings (also known as Cape) paints a very different picture: on this basis Europe ex UK is on a p/e of 14.9x, some 27 per cent below the 30-year average of 23.5x.
For comparison, the US is on a cyclically adjusted p/e (Cape) of 22.5x, roughly 9 per cent below its 30-year average of 24.7x. Avoiding the earnings problem altogether by using price-to-book ratios gives similar results: Europe ex UK equities are trading roughly 25 per cent below their 25-year average, while US equities are at a 15 per cent discount on the same basis.
Even simple p/e valuations should improve as Europe ex UK earnings recover alongside the global economy. Europe ex UK is likely to show the best earnings momentum in 2014, with consensus looking for 13 per cent earnings per share growth in 2014, up from 0.5 per cent this year. In the US, meanwhile, earnings growth of 10 per cent in 2014 will be a more modest acceleration from this year’s expected 6.2 per cent. Japan should have negative momentum going into 2014 after the massive earnings jump this year, while emerging market equity earnings momentum looks likely to be flat.
