CIO Viewpoint: Europe: Opportunities in adversity
By Stéphane Monier, Chief Investment Officer, Lombard Odier Private Bank
Pessimism on Europe, and optimism on the US (on tax reform, deregulation and growth) have been major equity market drivers this year. On 16 March our Investment Committee turned more positive on Europe, given the disparity in valuations, ahead of a swing in sentiment on US equities and the failure of President Trump’s healthcare bill. Longer term, we express caution on Brexit and governance in post-election France.
The good news: from Ghent to Aix
Political uncertainties have weighed heavily on European stocks this year. On forward earnings multiples, the spread between the S&P500 and the Stoxx Europe 600 is close to its widest in five years, despite a raft of data showing the eurozone in rude economic health. March Purchasing Managers Indices (PMIs) show eurozone manufacturing and services activity at a six-year high, and encouraging employment growth. A fifth of European companies tracked by UBS beat fourth quarter 2016 earnings expectations, another six-year high. We believe the current valuation of US markets (the S&P500 is trading at 18 times forward earnings) already prices in future tax cut benefits, which could well be delayed, while that of Europe (the Stoxx Europe 600 is trading at 15 times) scarcely reflects positive earnings revisions and lower interest rates. We recommend investors rebalance portfolios with this in mind.
Brexit and France: clouds on the horizon
Yet while this valuation discrepancy means we are positive on Europe in the short run, we have longer-term concerns on the bloc. Chief among our concerns are how the UK will handle Brexit, and the longer-term prospects for France and Italy. Here we would highlight the Swiss franc (CHF) as a natural hedge for European risk.
Deal or no deal for Brexit?
On 25 March, the European Union celebrated the 60th anniversary of its founding contract, the Treaty of Rome. Just four days later, UK Prime Minister Theresa May triggered Article 50, formally notifying the EU of the UK’s intention to leave. Unless mutually agreed by both sides, this gives two years to agree a divorce deal. Opening positions look unpromising: the UK wants to pursue simultaneous talks on a divorce and a new trade deal, but the European Commission wants the UK to settle the former, and pay a EUR60 billion ‘exit bill’, before the latter can begin. In our view, two years looks a tight timeframe to finalise both sets of negotiations. While an exit deal might require “qualified majority voting” of EU members (or 65% approval), we believe a new or even transitional trade deal might require unanimous member state, or even regional parliamentary, approval (such as that of Belgium’s Walloon region, which almost scuppered Canadian trade talks in October 2016). Ms May has already set out her stall that “no deal is better than a bad deal.” This seems a controversial negotiating stance when European leaders - and the European Parliament, which tends to defend the European project - already have little incentive to reach a favourable agreement. Fear of encouraging another member to depart amid a rising wave of populism and anti-EU sentiment looms large. Meanwhile, we have long held the view that even without the uncertainties surrounding Brexit, the UK’s twin budget and current account deficits (the latter among the world’s largest) are a concern. As such, we would recommend adding European equity exposure to other EU members, or Switzerland, rather than to the UK.
France: looking beyond Le Pen
The French presidential election is perhaps the biggest of current investor concerns over Europe, with an Ipsos poll released on 28 March putting support for far-right populist Marine Le Pen (25%) roughly equal with support for independent centrist Emmanuel Macron (24%). Although we treat polling figures with some scepticism, given market surprises on Brexit and Donald Trump’s election, we still believe the risk of a Le Pen victory is low. It is of course a worrying possibility, given her promises to take France out of the euro and hold a referendum on EU membership. But unlike Mr Trump, who promised voters a new direction, Ms Le Pen has been part of the French political establishment for some time: we therefore believe the polling data on her might prove more accurate. Even in the event that she scores a first round victory, we believe her radical policies could weigh against her in the second round, prompting rejected candidates’ supporters to rally against her.
But our principal concern on France is longer-term. The presidential race is typically held between two, centre-right and centre-left, candidates, but this year the electorate is fragmented. Whoever wins the race, they will need to form a coalition government that is capable of reuniting the country and implementing serious reforms, including on a chronic fiscal deficit, high taxes and public spending, which at 57% of gross domestic product (GDP) ranks among the highest of developed nations. Long-term unemployment remains stubbornly high, and despite modest growth, the French economy has still underperformed Germany, the UK and the US in recent years. This is a tough set of circumstances to inherit, even for a majority government with a clear mandate. Thus our main concern is not that Ms Le Pen wins the election and takes France out of the euro, but that through a volatile coalition, France moves further away from reforms, and loses the confidence of Germany and other partners in Europe
Data as of 27 March, unless otherwise stated.
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