It’s not clear whether a consistent positive relation exists between the average temperature on European beaches and market performance, but since the start of the summer, global investors seem to look with a different eye to the European equity market.
Although we must not get carried away – as one swallow does not make a spring – investors did rightfully become more positive on Europe.
For a start, Europe emerged from recession in the second quarter. The improvement was broad-based with both Germany and France beating expectations. The UK from its side continues to surprise on the upside, as witnessed by rising house prices, retail sales and industrial production data. A recovery in the US and Japan, a somewhat lesser focus on fiscal austerity, easy monetary policy, and a fading of the systemic risk perceptions are at the basis of this recovery.
Second, earnings growth has troughed and there is an expectation for acceleration into 2014. Taken into account the high sensitivity of European earnings to even a small improvement in revenues, there could be margin expansion and double-digit earnings growth next year provided the global growth environment remains benign.
To make the picture even more compelling, this earnings growth does not come at a high price. The price earnings ratio of European companies is 15 per cent below the global average. Relative to the US, the discount is even 35 per cent, which is close to historic highs. Sure, Europe – or at least the eurozone – has some unique challenges in building a more stable monetary union, and these probably warrant a discount, but not 35 per cent.
The equities market is not only attractive relative to its peers, but also when held up against the bond market. The dividend yield on European equities is 3.6 per cent, almost double the level on a German bund. However, there is one important difference. A combination of tapering in the US and improving macro data will most likely drive bond yields higher, leading to a loss on the bond holdings whereas dividends have ample room to grow given the better profitability of companies and the high level of retained earnings.
This is also an incentive for companies to gear up their balance sheet. Replacing expensive equity capital by cheap debt reduces the average cost of capital, lowers the hurdle rate for new investments and increases the return on equity. This must sound like music in the ears of equity investors.
They seem to have embraced the theme. There are signs that the rotation from bonds to equities may be around the corner. This will not happen overnight, yet for the first time since 2007 equity inflows have surpassed bond inflows, and more recently this trend accelerated.
Patrick Moonen is senior strategist of multi-asset at ING Investment Management
