Equity markets were far more interested in Chinese factory data and Wall Street’s performance on Friday than the election in the world’s fourth largest economy. Is it the case that the European elections are more important for what didn’t happen than what did?
Structural significance
The result was a significant personal endorsement for Angela Merkel. Although she did not get an overall majority, she came closer than almost any other Chancellor since the Second World War. David Moss, director of European equities at F&C Investments, said the result provided Merkel with "a strong platform for her to continue to drive her agenda".
This is good news for the eurozone project as a whole. Moss says that Merkel has recognised the importance of the stability provided by the single currency for Europe and the help it has provided for Germany as a major exporter: “This has enabled her to support bailouts for Greece, Spain and Portugal, the establishment of the outright monetary transactions, and help drive significant progress to centralised bank supervision by the ECB.”
It is also good news for the stability of Europe as a whole. Prior to the election, there had been fears that extremist parties, in particular the rapid rise of the anti-euro party, might force an uncomfortable coalition on Merkel, diluting her agenda and restricting her ability to negotiate in Europe. This is now less likely to happen, though Moss believes that markets may be holding back until they see the final results of the coalition: “We must wait until the new Government is formed to see what roles other parties will have, and what impact these could have on policy. As ever investors will be less happy with this period of uncertainty.”
Investment shift
He believes that ultimately the election result is good news for European equities. Certainly, it is likely to support the shift in sentiment towards European equities seen since the start of the summer. A recent Goldman Sachs survey found that US institutional investors were directing more money towards European equities than at any other point since 1977. The most recent BofA Merrill Lynch Fund Manager Survey reported a similar shift in sentiment. This has largely been driven by the region emerging from recession over the summer.
However, to date, there has been no notable outperformance of European equities, which would suggest that asset allocators are simply correcting a long-held underweight position rather than establishing a new overweight position. This means, according to Nicolas Simar, head of equity value boutique, ING Investment Management, that European and eurozone equities remain cheap: “Everyone agrees on this,” he says.
“The cyclically adjusted PE ratio is at a 40 year low in Europe and the 30% discount versus the US market on the same metric is substantially higher than the 10-15% long term average European discount. Besides this, while US earnings are 20% above previous 2007 cycle peak, European earnings remain 30% below that same cycle peak, leaving ample room for European earnings to close the gap.”
What wasn’t said?
The election provides the benign backdrop for confidence to build and this rally to continue. Simar argues that investors need to leave the "secure and defensive growth side of the market" and add to "more eurozone domestically exposed type of companies in cyclical and financial industries". He points out that the valuation gap between these two types of equity has risen to a 15-year high.
Barry Norris, manager of the IM Argonaut European Alpha fund, has recently been shifting his portfolios towards more economically sensitive parts of the economy, encouraged by recent growth signs from the region. As tail risks, such as the German election, are progressively removed, more managers are likely to follow suit.
The German elections were good news for equity investors because nothing much changed, thereby maintaining a neutral backdrop from which confidence in the eurozone recovery can build. Any sign of a challenge to Merkel’s agenda, or a significant rise in extremist parties, would have disrupted this process.
As it is, the German election is more important for what didn’t come to pass, than Merkel’s unequivocal return to power.
