This last week has been tough for the markets. What began on the previous week with a correction in commodity prices has now moved to the stock markets. “Investors have realized that global growth is slowing down,” said Neil Dwane, Chief Investment Officer for European Equities at Allianz GI, in an interview with Funds Society. As pointed out by this expert, this situation was triggered by weaker-than-expected inflation data in China, and especially “the negative PPI data, which raises concerns of a serious scenario for commodities and growth, coinciding with the end of tapering”.
Thus, investors are reacting to a scenario of lower growth and rising interest rates. A combination that last week led to yields on government bonds in Italy and Greece reflecting new concerns about sovereign risk in certain countries of the Eurozone. Some truncated corporate transactions, such as the U.S. pharma AbbVie’s takeover bid on UK’s Shire Pharma, have tumbled an entire sector, “bringing some hedge funds down along the way with bulkier positions,” added Dwane.
“All these factors represent a setback, so maybe it's time to reassess the positions on our portfolios” he explains, adding that technical factors have also helped to aggravate the situation short-term because up until this week US$20bn of the US$70bn which North American investors had assigned to the European stock markets in recent years, had already flowed out, “but surely last week there were further outflows.”
If before this week, European equities were cheap, both in absolute terms and especially in relative terms to U.S. equities, now they are even cheaper. Dwane points out a number of factors to consider when allocating assets to European equities:
- AQR (Asset Quality Review)- in late October, the ECB has to give its verdict on the quality of Eurozone banks. Until the last LTRO auction, this was never considered a very important event as the ECB had not been aggressive with the banks, “which is negative, because the banks need to recapitalize and if they don’t, nothing can change in Europe.” However, Dwane believes that after the banks’ lukewarm reception of the last auction, the ECB will be harder with European banks, forcing them to “ask for capital, which is something that they really need, so that within a year they will be ready to give credit,” thus helping the European economy to grow. So, something that at first may seem negative for banks and for the market as a whole, would be positive in the long term, and will provide an an opportunity to enter the market at more attractive prices.
- Changing political disposition- this is an additional source of instability for Europe. Until now, European politicians have not taken the need for change seriously. “Countries like Spain and Ireland have taken measures, but others like Italy are still evasive. With this setback, markets are really challenging politicians to undertake change. While in the short term this means more uncertainty, if there is evidence of a serious political commitment from countries like Italy, France, and even the ECB, the European stock market could rally strongly.
- Weak Euro -This is the factor which undoubtedly provides greater support for European corporations, their profits, and therefore their share price. “Unlike the detrimental effect of a stronger dollar on emerging markets, which see a rise in both the cost of the goods they need to import, and the cost of refinancing their debt, for Europe, a weak Euro against the dollar represents an extensive competitive advantage for their companies.” Dwane highlights that the effect of a weaker Euro will start to show up in corporate profits after a while, but even if it comes with a time lag the markets will welcome it. He adds that if you look at historical data, the average dollar rally is usually 20%, in this case it only accumulates a 9% rise so statistically, it could continue. “Probably in a few months we will start to see recommendations from analysts advocating buying Adidas and selling Nike, due to the effect of the dollar,” he added as an example.
Considering the risks and opportunities in European equities, Dwane concludes by pointing out not to lose sight of the attractive valuation of many of the European markets relative to the U.S. Using the cyclically adjusted PE ratio, and not even considering the market drop in recent weeks, the U.S. trades at a PE ration that exceeds 25x, while Germany, Netherlands, France, UK, Spain, Ireland, Italy, Portugal, and of course Greece, are clearly trading below the historical average for this ratio, which is in the vicinity of 17,5x.
This, Dwane notes, “does not have to result in a better performance of European markets over the U.S. in the coming months, but statistically there is a high probability that the annual returns of the U.S. market over the next decade will be around 2%, while that of Greece, would be of 15%.”
Allianz GI suggests two strategies for partaking in this future return given the current market environment: first, quality growth. Dwane explained that “there is corporate growth in Europe, but you have to know where to find it; the current environment is best for stock pickers.” On the other hand, a good argument in times like these is investing in companies with high dividend yields. To begin with, they receive the support of the global search for yield, and currently they offer a higher yield than that of European corporate bonds. In addition, companies that pay dividends tend to behave with less volatility than those that do not.