Surprises in European equities

Why have European equities performed so well in 2019 and what are the prospects for 2020?

For much of 2019, European equities were an unloved asset class, shunned by investors. At first sight, this was understandable – the region is growing only slowly, wracked by political tensions and wrestling with headwinds in vital sectors such as the German car industry. Investors often want to hear a story before buying or selling a market – and, for many commentators, the story was a negative one.

Yet, European equities have actually performed rather well in 2019. By mid-December, Europe’s main indices had risen by about 20% since 1 January 2019. This may be less spectacular than the US stock market’s gains but gives Europe a clear lead over emerging market (EM), Japanese or UK equities.

What’s going on? As the famous economist John Maynard Keynes purportedly said: “When the facts change, I change my mind. What do you do, sir?”. Equity markets can climb a veritable wall of worry if they perceive better times ahead.

Trade has been one area to focus on. Twelve months ago, investors became very nervous about the effects of a US-China trade war on Europe, adding to concerns about the manufacturing sector recession in Germany. These fears have been allayed by more measured statements from the US and China. Strategic rivalry between the two superpowers remains, of course, but a major economic collapse suits neither president at this point in their political careers.

On the economic front, in recent weeks we’ve seen early signs of a modest revival in European business activity and investment plans. This has been helped by interest rate cuts in the US, China, many EMs and, in particular, Europe. As a result, government bond yields have fallen. For instance, yields on German government bonds have moved into negative territory, from +0.2% to -0.3% over the past 12 months. At the same time as share prices have risen, European companies have struggled to eke out profits growth. Consequently, the European equity market has revalued – and become rather more expensive. For the Euro Stoxx 600 Index, the ratio of share prices to earnings moved from 13 to almost 19 over the year.

It’s worth looking at which sectors drove this rally in European shares, and which held it back. This reveals differing industry fortunes and gives an indication of future risks.

The four sectors which performed best and added most to the performance of the European market were: information technology and industrials (up over 30%) and healthcare and consumer stocks (up over 20%). The importance of growth prospects, shifting views about cyclically sensitive areas, the continued strength of household incomes and a reassessment of regulatory pressures all played a useful part. For example, strong cashflows from pharmaceutical companies were supported by lower bond yields, while medical technology did well because of its perceived defensive characteristics.

It is also worth looking at the laggards, which helps explain why European equities didn’t perform even better, or might have performed worse! These sectors comprised communication services and energy (close to zero return) and financials (up only 13%).

Some issues are sector-specific. Telecoms as a whole offer poor returns due to regulation and overly competitive markets. Additionally, they face long-term pressure on capital from the need to continually invest, for instance in 5G networks. Macroeconomic factors were important too, such as the relatively low oil price. Financials have a large weighting in the market. Serious questions were asked about the operating model for banks when German bond yields reached an all-time low of -0.75%. However, subsequent interest rate movements, slight improvements in regulation and encouraging bank earnings reports prompted a rebound. A modicum of good news can go a long way when investors are underweight a market or sector.

What about the prospects for 2020? We still see Europe as more of a stock-pickers’ market, full of attractive stocks but facing some major headwinds. Possible upside for Europe could come from clear signs that the manufacturing recession is ending, or agreement among EU politicians to loosen the purse-strings on government spending. Evidence that US investors see less political risk in Europe and are poised to rotate into cheaper assets could also herald a rally in European equities.

We see Europe as a stock-pickers’ market, full of attractive stocks but facing some major headwinds.

The downside scenario must also be considered. Has a strong 2019 – when companies benefited from exceptionally low interest rates – simply pulled forward performance from the future? Can European companies grow their profits, or must they cut their dividends to conserve cash? Dividend payout ratios and interest cover are two widely used measures of the likely sustainability of a firm’s balance sheet. The recent rise in the dividend payout ratio and falling interest cover are warning signs. The weakness of Chinese economic growth, which particularly affects European exports, and the regulatory burden from the EU are other factors to monitor.

On balance, we are neutral European equities versus other global markets. However, at the same time, we emphasise that Europe is an attractive stock-pickers’ market. Areas of the stock universe which are relatively unloved offer some compelling opportunities for active investors. The total return of European equities is also worth examining. Although the European stock market has merely returned to the highs seen back in 2015 and 2018, over the past five years dividend growth means the total return is closer to 7% per year - much better than cash, for an investor willing to accept the ups and downs of the market.

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.