Sam Morse, Manager, Fidelity European Values.
The dramatic improvement in market sentiment that took place during 2013 saw continental European equity markets rise by some 26% over the year as a whole, putting them only just behind the US in terms of returns to a UK based investor. Given the similar magnitude and timing of the recovery in the two markets it is tempting to think that their performance will continue to be coupled for the next market phase; however I believe that it is important to look a little deeper and understand exactly what was driving this performance. In the US while increased investor confidence saw PEs increase, this multiple expansion was underpinned to at least some extent by a corresponding increase in corporate earnings. The performance of continental European markets however was driven entirely by multiple expansion; not only was there no contribution from increased earnings, but since March 2012 EPS growth has actually been negative in Euro terms.
It is tempting to make a case for continuing strong advances in European markets based on their relatively lower absolute PE levels, certainly when compared to the US. However I believe that it is more likely that expectations of a European recovery are already well baked into share prices, in particular for domestic-facing stocks in peripheral Europe. To move significantly beyond current levels would require belief that corporate earnings growth will be significantly higher than the levels already discounted by the market. I think it is harder to make a case for believing this will happen now than it was a year ago. Economic growth in Europe is highly anaemic, and the ECB is preparing the market for more extreme QE measures to stave off the looming spectre of returning deflation. M&A activity, typically a late cycle phenomenon, is picking up sharply and has returned to pre-2007 levels as companies are tempted to acquire external sources of growth by the zero real return available on their cash balances. That’s worrying.
So is this a signal to abandon continental European stock markets altogether and seek returns from other markets? I don’t believe that it is. I still feel that there are quality, cash generative companies with strong balance sheets in Europe that can continue to benefit from global recovery even though their domestic economies remain weak. The good news is that thanks to the value rally of the past twelve months these companies are now relatively cheaper than they were, and are now very much more within the range of an investor like myself who looks at a company’s ability to sustain and grow its dividend from its own internal operations as a key indicator of it’s overall health.
Hence the deliberate ‘double entendre’ in my chosen headline for this article. I believe that given the events of the past twelve months, the top performers of the next market phase will be determined not by sector or by country, but by strength of their underlying franchises and balance sheets. Stocks which are already discounting considerable cyclical earnings recovery remain vulnerable to a shift in sentiment, which could yet be triggered by the continued smouldering of political and economic events in the emerging markets.
2014 marks my twentieth year as a portfolio manager, and one of the many lessons one learns along the way is that while history may not repeat, it does have a habit of rhyming. Sir John Templeton described the phenomenon of equity investing thus: ‘Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria’. We may not be euphoric yet, but without a strong injection of earnings support, there is certainly evidence that we may well be into a period of increasingly stretched optimism.