Emmanuel Macron’s win in the French presidential election represents the third defeat for populism in Europe, after recent elections in Austria and the Netherlands. The German elections, coming up this September, are less worrisome for investors: the popularity of Euro-sceptic Alternative for Germany (AfD) party has now fallen to dismal levels in the polls and in losing its leaders it has made the election a straight fight between Angela Merkel’s Christian Democratic Union and Martin Schulz’s Social Democratic Party. Importantly, neither party scares the markets. The Italian elections, though, may have the potential to upset the applecart but they are unlikely to happen until 2018. And with disruptive headlines about the Brexit negotiations on the backburner for a short while, a populist-free year in Europe may be on the cards.
This may surprise many market participants who expected European countries to fall like dominoes in a populist wave. The view was so widespread that when President Trump took office, he asked which country would be next to leave the EU. Asset allocators were therefore reluctant to invest in Europe and consequently have large underweights to the region. Indeed, before the first round of the French presidential contest, some had shorted European equities outright and were forced to cover on the following Monday, pushing stocks up by 4%. A few brave souls bet on the second round result and took profits afterwards, but long-term investors have been noticeably absent.
A sharp reduction in political risk helps European markets but would hardly suffice if it weren’t for another two ingredients: a Eurozone recovery and cheap valuations. The upswing is impressive by European standards: Purchasing Managers Indices (PMIs) are hitting levels of 55-57, unemployment is decreasing, core inflation has bottomed, wages are outstripping prices (2% vs. 1.2%) and the euro has bounced back three times now. Even the persistent laggard, the banking sector, is healthier than in post-crisis memory: improved capital ratios, rising lending to businesses and individuals and fewer non-performing loans. No wonder Standard &Poor’s, a ratings agency, upgraded German banks and Santander, a Spanish bank, raised its dividend. Crucially, this is not a short-term artificial boost, unlike the US dollar strength of late 2014-early 2015.
For what it’s worth
Equity valuations have always been bandied about by euro-bulls. Europe is always cheaper than the US, so you have to apply a comparability screen. Using that method, the US Price Earnings Ratio (P/E) is 1.27x its long-term average, vs. 1.14x for Europe. Enterprise value to sales (EV/Sales) in the US is 1.33x its long-term average vs. 1.22x for Europe. European margins have lagged US margins, but are recovering: 11.3% vs. last year’s 9.8%. However, there is more room for improvement in Europe. Many sectors are trading more cheaply in Europe than in the US (financial services, energy, consumer discretionary and utilities) but the discount for being European-based won’t last if the political risk is abating.
The European Central Bank (ECB) may also help, as Mario Draghi, its president, may modulate his rhetoric in light of the more balanced economic backdrop. He is likely to hint at a different monetary policy blend, with more tapering and higher rates on the horizon. This should drive German Bund yields up and help European bank stocks as well as cyclical sectors.
Even if investing in Europe is no longer seen as toxic, not all the ’juice’ has been driven from the trade. Most commentators still quote the list of future elections as a hurdle to investment. This is reminiscent of the post-crisis period when many baulked at buying risk assets due to a litany of problems ahead – the sovereign debt crisis being a significant one – and eventually capitulated when those issues waned. The incipient outperformance of euro zone stocks this year is founded on solid ground but is still destined to climb the proverbial wall of worry, before becoming overbought.
Long-term risks in Europe have not vanished, though, as some countries benefit from the Union more than others. The next global recession may highlight these issues once again. One potential solution would be for Germans to up their spending and thereby carry the rest of the euro zone through higher imports. Will the next Chancellor be willing to encourage consumption for the good of the EU?
Political biases won’t vanish overnight, however: mathematically, with 27 countries in the EU (post-Brexit), half a dozen will have elections every year. The European political scene will provide plenty of nail biting in the years to come.
Culled from The Economist Intelligence Unit.