The first important point is the general recovery in economic confidence in Europe. This matters because it should nurture a change in behaviour among both companies and households, which were badly affected by the financial crisis and the subsequent sovereign debt problems and became very risk averse. Statistics show that both companies and households have been using income to reduce indebtedness. Whilst this is prudent, it hurts final demand in the economy. With growth around the world picking up, companies are becoming less risk averse and more likely to invest in their own business. At the same time, unemployment in Europe has peaked and is now trending down. High unemployment was a product of the painful but necessary reforms in the peripheral countries, but those reforms are now paying off as competitiveness is re-established. Rising confidence among households will encourage consumption.
The second factor is the strengthening of Euro area banks and financials, a sector where we expect earnings and dividends to grow. This process will be accelerated as we near the end of the ECB’s stress test (the Comprehensive Assessment). This was designed to examine the quality of bank lending and to ensure that capital was sufficient to survive a serious economic downturn. Banks have been raising capital steadily for the past twelve months – for instance we have seen successful rights issues from Portuguese and Italian banks in 2014. The intention of the ECB is to revitalise lending, and whilst the last eighteen months has seen the stress test act as a constraint on banks, we see the provision of credit recovering healthily as we move towards the year end. This recovery in credit is important – it will sustain the growing confidence of companies and households. In both areas, a replacement cycle for ageing assets (whether this is plant and equipment, or cars and washing machines) is now overdue.
The third theme is investors pursuing domestic (rather than international) growth where more attractive valuations can be found. In our view, the same stocks that have driven markets higher over the past five years are unlikely to be those that benefit most from the current environment. For example, those companies with emerging markets exposure did well during the Eurozone crisis, but as emerging market economic growth has weakened, and domestic European growth has improved, market leadership has shifted towards more domestically-focused companies.
The recent steps announced by the ECB will help to further strengthen the Eurozone economy, firstly by encouraging banks to circulate money in the wider economy rather than to park it with the central bank, and secondly by providing cheap funds specifically for lending to small and medium-sized companies. One of the effects that we have observed since the ECB’s meeting in June has been a modest weakening in the Euro exchange rate, and this is important because the strength of the currency had previously acted as a headwind to internationally-oriented companies. That headwind is now dissipating.
Market expectations are for earnings to grow in the current year and for the next two years, and this growth in earnings will support further modest rises in markets, even if there are bouts of volatility and nerves along the way. The current yield on equities is attractive, and there is scope for these dividends to grow along with earnings. Relative to bunds and to cash European equities certainly offer attractive valuations.
