The rush of money into euro zone equities has killed the bargain basement appeal these stocks once had, but investors keep piling in because they believe accelerating economic growth will deliver further gains.
Western Europe saw $62.1 billion in equity fund inflows from January through April, according to Boston-based data provider EPFR Global, up from $40.6 billion in the same period last year. Analysis of fund flows for individual countries suggests that the bulk of this money has gone into the euro zone. The influx has fueled a strong stock market rally. The Euro Stoxx 50 index of euro zone blue-chip shares was up 15.9 percent for the year-to-date as of May 7, versus a 1.4 percent gain for the S&P 500 index.
Alain Bokobza, head of global asset allocation at Société Générale in Paris, thinks he knows why so many investors are coming — and why they’re not. “The rise in euro zone equities has erased their undervaluation against U.S. equities,” he says. “So if people stay bullish on euro zone equities, this is no longer because they are cheap.” As of April 30 the 12-month forward price-earnings ratio for the Euro Stoxx 50 was 15.4, compared with 17.2 for the S&P 500.
So, what’s the attraction? Those P/E numbers are based largely on companies’ forecasts, and Bokobza thinks they’re too pessimistic. Because of the negative shocks to earnings in past years triggered by the euro zone financial crisis, “companies that report earnings to the market have learned to be very cautious in their communication policy,” he says.
Bokobza believes corporate earnings will be significantly higher than company forecasts because the conditions for earnings growth are favorable. Usually, economies have a good outlook that forces a tighter monetary policy to curb the resulting inflation, or a muted one that allows for looser policy, he notes.
But Bokobza calls it “very rare” to have what the euro zone enjoys now: monetary loosening, courtesy of the European Central Bank’s €1.14 trillion ($1.27 trillion) quantitative easing program, just when economic growth is gathering speed. The euro zone will see gross domestic product expand about 1.5 percent this year, according to consensus forecasts, up from 0.9 percent in 2014. Because faster growth and looser monetary policy are both good for stock prices, “European equities will see a vintage year in 2015,” Bokobza predicts.
Société Générale forecasts earnings growth of 15 percent this year and 14 percent in 2016 for euro zone stocks, but Bokobza thinks the real numbers might be higher.
Investors reckon that earnings prospects for euro zone companies will prove robust in part because they’ve been so poor in the past. The key dynamic here is operational gearing, which relates to how much increased sales translate into profit.
“Europe was in a very severe economic place” a few years ago, says Alexander Gunz, manager of the $27 million Helicon Global Equity Fund at $9.7 billion, London-based Heptagon Capital. “A natural response was to take headcount out. So there’s very high operational gearing that should translate into attractive earnings growth as euro zone economies recover.” Like Bokobza, Gunz believes euro zone companies are playing down the earnings growth that will follow.
The sense that earnings may be better than expected could keep money flowing into Europe, but it won’t necessarily go to the same places as before. When considering just country-specific funds, Germany attracted the largest share of net inflows in the first four months of this year, at $2.2 billion, EPFR reports, but in April alone the country had $2.7 billion in net outflows; the biggest inflows that month went to Spain, at $481 million.
Amber Capital, a £1.5 billion ($2.3 billion) hedge fund firm headquartered in New York, tapped into the euro zone periphery in December 2013 with the launch of the long-only Amber Southern European Equity Fund. The €450 million vehicle began by targeting “southern European companies not that exposed to southern Europe — companies penalized for being in the wrong ZIP code,” says Joseph Oughourlian, Amber’s London-based chief executive. But recently, the fund has changed its philosophy and started investing in companies with strong exposure to demand in southern Europe.
He cites Italcementi, Italy’s biggest cement maker, which he sees as a double play, on exports — it’s the market leader in France and in parts of the U.S. — and on a domestic recovery. Thanks to the collapse in Italian cement consumption from an annual peak of 40 million metric tons in 2006 to only 20 million, “Italy has completely disappeared from this company’s earnings,” Oughourlian says.
But because of what he calls Italcementi’s “drastic” cost-cutting at home, “even if the market just goes back up to 25 million tons, the positive effect of operational gearing will be huge,” he adds. Italcementi, whose stock price surged 27 percent between January 1 and early May, will also continue to gain from the weak euro, Oughourlian wagers.
