Weekly Market Commentary - European Head Fake?
The much anticipated European Central Bank (ECB) policy meeting this week may include a quantitative easing (QE) program announcement. Although we would view a potentially bold QE program from the ECB as an incremental positive, the ongoing growth and deflation challenges in Europe leave us still with a strong preference for the U.S.
EUROPEAN HEAD FAKE?
The European Central Bank (ECB) is likely to announce a quantitative easing (QE) program involving European sovereign bond purchases at its upcoming policy meeting on January 22, 2015. Recall back in September of 2014, in our two-part Weekly Market Commentary “Don’t Fight the ECB?” we highlighted several reasons for favoring U.S. equities and largely avoiding European equities, despite the ECB’s prior stimulus efforts and potential for outright QE. With QE likely forthcoming, we revisit the opportunity in Europe, which we believe may be setting the stage for a head fake.
WHAT WE ARE WATCHING
As we evaluate the opportunity in European equities, here is what we are watching:
* Economic growth * Inflation * Earnings * Valuations * Loan growth * Relative strength
Economic growth gap between the U.S. and Europe is widening. The U.S. economy has been growing faster than Europe in recent years based on real gross domestic product (GDP). Based on the Bloomberg-tracked consensus of economists’ forecasts for the fourth quarter, Eurozone GDP grew 0.9% during 2014, compared with 2.3% for the U.S. We expect that gap may widen in 2015, as our forecast for U.S. GDP growth (discussed in our Outlook 2015: In Transit publication) is at least 3%.* Even with QE, we do not expect growth in Europe to accelerate in the near term, and as a result we expect this growth gap may widen — although the gap in the third quarter of 2014 of more than 4% (5.0% in the U.S. versus 0.6% in the Eurozone) is not expected to be sustained.
Deflation risk remains high. Sluggish growth and structural challenges (more on that to come) have led to deflation in Europe, which could result in delayed purchases and investment, further slowing the economy. December 2014 annual inflation in the Eurozone was just -0.2%, or 0.8% excluding food and energy (Eurostat data), not anywhere close to the ECB’s 2% target. Meanwhile, inflation expectations have continued to fall. QE could help a bit in this regard, but we do not expect it to be enough to drive a sustained gain in prices, especially when considering the lack of economic growth.
Earnings mirage. Earnings are expected to increase by 25% in Europe, year over year, in the fourth quarter of 2014. But the gain is all due to depressed financial sector earnings a year ago, which are propping up earnings growth for that sector, while revenue growth is nonexistent. Just three Euro Stoxx 600 sectors are expected to grow earnings based on Thomson Reuters estimates, while eight S&P 500 sectors are expected to grow earnings year over year (for an overall expected mid-single-digit gain).
Although S&P 500 revenue is only expected to grow about 1% during the fourth quarter of 2014 (despite the 15% expected drop in energy revenue), that looks good compared with the 2.1% revenue drop expected for Europe. We expect slow growth and extremely low inflation to continue to weigh on European earnings, despite the export benefit of the weak euro.
European valuations look cheaper than they are. European stock valuations (excluding the United Kingdom) are lower than those in the United States based on price-to-earnings ratios (PE) [Figure 1], and they have gotten cheaper since we last wrote on the subject. The discount is currently 12% on a trailing PE basis and 17% on a forward basis.
Adjusting for sector mix (the S&P 500 is much more growth oriented, which carries higher valuations), these discounts close significantly. For example, technology makes up about 17% of the S&P 500, compared with just 4% of the MSCI Europe Index, while the MSCI Europe has about triple the weight of the S&P 500 in telecoms and utilities (11% versus 4%). Given the economic growth gap and sector mix, we currently do not find the valuation discount to the U.S. particularly attractive.
Credit still not flowing. The fractured banking system may mute the effectiveness of QE, because increases in the money supply have not translated into loan growth [Figure 2]. Banks are still undercapitalized and some of the region’s banks still have problems with bad loans, which, when combined with economic uncertainty, is constraining lending. Credit is the fuel for economic growth and European private sector lending — though falling more slowly — is still down 1.1%, year over year, in the latest reported period (November 2014).
Relative strength trend still negative. Since the start of the current bull market in March 2009, European stocks have struggled mightily, relativeto the U.S. In 2014, Europe’s loss (based on the MSCI Europe Index) trailed the S&P 500’s 13.7% gain (total return) by more than 19 percentage points, and Europe has slightly underperformed the U.S. so far this year through January 15, 2015 [Figure 3]. From a technical perspective, we have not yet seen enough sustained relative momentum to signal an attractive opportunity relative to the U.S (we should note we are getting closer in emerging markets [EM]).
Although we would view a potentially bold QE program from the ECB as an incremental positive, the ongoing growth and deflation challenges in Europe leave us still with a strong preference for the U.S. and a belief that any short-term rally may be short lived. For overseas opportunities, we would first look to EM with a focus on Asia. European valuations have become a bit more attractive and the weak euro may help drive more exports, but we would like to see more fundamental and technical improvement — and get past the risk that the ECB disappoints — before considering a possible Europe trade.