European equities – Should investors care about periphery vs. core anymore?

Dan Ison, Portfolio Manager | January 13, 2014

  • The more dramatic the economic reforms, the better the stock market performance in the eurozone
  • We expect nominal growth to be the key driver of an improving earnings picture in Europe
  • European equities should show further good returns to investors in 2014

As we enter 2014 there are the usual questions, conversations and strategy pieces extolling the virtues of different regions and asset classes. 2013 saw a phoenix-like resurgence in interest for European equities with an interesting mix of winners and losers. The best performing markets (all returning more than 33% for the year) were Greece, Finland and Ireland. Of the larger markets, Germany, The Netherlands and Spain were the best performers while France, UK and Italy were the worst. Four years since the start of the Euro Crisis (Greece late 2009), can we finally stop worrying about the periphery versus the core?

 Year-to-date performance (in euros)

Returns of different markets in Europe.

Source: Threadneedle International Limited*, December 2013. Past performance does not gurantee future results.

What can we glean from last year’s equity market performance? On the face of it, not too much. What is certainly true is that countries that have enacted the more dramatic economic reforms have delivered better equity market performance of late (with the notable exception of the UK). In other words, despite significant external pessimism about Europe’s ability for self-help, it has begun to work. Despite this, aversion towards investing in Europe remains high, even within the region. Many people have forgotten how to invest in a bull market — indeed many market participants (in Europe at least) may never have experienced a true bull market at all. Of this, more later…

Unit labor cost evolution, rebased to 100 in 2000

Unit labor cost evolution

Source: Threadneedle International Limited

Spain and Ireland are certainly the poster children of eurozone reforms. Both have exited their troika programmes (bailouts composed by European Commission, the International Monetary Fund and the European Central Bank). Spain can easily finance itself in open markets while Ireland is preparing for its first bond sale since the bailout. Unit labor costs, a good proxy for competitiveness, have fallen significantly in these two economies — by 16% from the peak in Ireland and by 8% from the peak in Spain. In less reformist countries like France and Italy, this measure is essentially flat. Perhaps more importantly, employment is now growing in Spain and Ireland. December saw one of the biggest monthly improvements on record for Spain. Labor reforms from 2012 should keep wages in check as employment expands again. In Ireland recent data saw a clear rebound in gross domestic product (GDP), with particular strength in building and construction and investment in machinery and equipment. Property yields in Dublin have contracted from 8% to 6% in the past year, where there has been no new Grade A office space built in the past five years and vacancy rates are less than 5%. Rents halved from 2007 to the trough, but have already recovered some 30% off the bottom.

All this has contributed to a more positive general sentiment across Europe. For example, in a recent survey Germans were revealed to be more optimistic about the future now than at any time since the mid-1990s (source: Allensbach Institute).

Service PMI’s in Germany and Spain have rallied above 50, signaling expansion…

Isonchart3

Source: Threadneedle International Limited

 

…while in France and Italy there is little sign of recovery

Isonchart4

Source: Threadneedle International Limited

 

The economies of France and Italy remain more troublesome. President Hollande recently conceded that France is overtaxed. Here is a socialist leader effectively calling for tax cuts and a slimming of the (very bloated) state sector. Italy remains a curious mix of reasonable economic data coupled with possibly the most baffling political situation in the developed world. The lack of strong government certainly hinders Italy’s ability to reform. I am often reminded that despite being the world’s 8th largest economy, Italy hasn’t grown in more than a decade.

While the UK has likely enjoyed the strongest European GDP growth in 2013, her equity market has lagged many of the major markets in Europe. Here we find a simple explanation — market structure. With 25% of the UK market comprising commodities and oil, and a further 28% in defensive growth sectors, the UK in market capitalization terms can be considered quite unrepresentative of UK GDP. The mid cap index, typically more exposed domestically, enjoyed a healthy rise of 25% in euros, more than double that of the FTSE100.

Our conclusion is that it is too simplistic to talk about periphery vs. core. We can see clear signs that European economies which instituted the bolder (and generally tougher) reforms are now showing the largest deltas in their expected growth rates for 2014 vs. 2013. In the traditional core, France stands alone as the one country not currently expected to see a significant growth pick-up this year.

We continue to favor developed markets over emerging markets, domestic growth over international growth and cyclicals over defensives. We expect to see real economic growth return to Europe in 2014, and with this comes nominal economic growth. It is the nominal growth which propels top-lines and generates operating leverage. We expect this top-line growth to be the key driver of an improving earnings picture in Europe in 2014 and beyond. Our (hopefully conservative) earnings forecast stands at 10% for 2014. European profits have a long way to catch up with other developed markets, and it is primarily for this reason that we remain confident that European equities will show further good returns to investors in 2014. Finally, we believe 2014 will conducive for active management and we expect the market will amply reward active stock pickers over passive investing.

*Threadneedle International Limited is an FCA- and a U.S. Securities and Exchange Commission registered investment adviser based in the UK and an affiliate of Columbia Management Investment Advisers, LLC.

Dan Ison

Portfolio Manager
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