This article was written by Invesco PowerShares Vice President, ETF Product Management, John Feyerer.
The never-ending Greek tragedy continues to take twists and turns as the news surrounding Greece’s fate in the European Economic and Monetary Union (EMU) seems to change minute to minute. This saga has and will likely continue to result in greater volatility in equity markets, yet could also provide potential buying opportunities for European stocks as the dust settles. As pundits opine on the likelihood of various outcomes from the current crisis, I believe investors should step back and evaluate the longer-term opportunity to invest in the eurozone.
Eurozone economic indicators point to continued expansion …
With the eurozone accounting for 17% of the world’s GDP1, I believe globally minded investors clearly need to contemplate a strategic allocation to this region. Trends in the major economic indicators point to continued expansion, which should bode well for equity performance in Europe. Business activity in the 19-member bloc expanded at its fastest pace in four years in June, as measured by the Markit Composite Purchasing Managers Index (PMI), which tracks manufacturing and service sector equities The indicator rose to 54.2 (from 53.6 in May), representing continued solid footing above the 50 mark that divides expansion and contraction.2 PMI data from Europe’s two biggest economies – Germany and France – also painted a bright outlook for the eurozone economy. The survey also indicated that employment and new orders had risen at the strongest rates in four years over the second quarter, although growth slowed in both cases in the month of June as concern over the re-emergence of the Greek debt crisis surfaced yet again.
… While technicals are still supportive
Eurozone stock prices, as measured by the Euro Stoxx 50 Index, maintained levels of support across the previous highs established in June 2014 and November 2014 — between 3,275 and 3,375, as seen below. In addition, the chart illustrates that the Euro Stoxx 50 Index is still firmly in the uptrend established in September 2011, while still 25% off the market highs established prior to the global financial crisis.
European stocks are in an uptrend, but still off of market highs
Euro Stoxx 50 Index high, low and closing values from Aug. 1, 2003, to July 6, 2015
Additional tailwind courtesy of the weak euro?
The 17% drop3 in the value of the euro relative to the US dollar since June 30, 2014, coupled with the tremendous run-up in European equities earlier this year, begs the question: Where do eurozone equities go from here? Historically, the year-over-year change in the EUR/USD exchange rate has led the direction of the Euro Stoxx 50 Index by approximately one year. Therefore, euro weakness in the past portends continued upside for eurozone equities, in my view. The chart below illustrates the strong correlation between movements in the EUR/USD exchange rate and the region’s subsequent one-year stock market performance. As described above, the strong PMI levels should augur strong earnings growth, which would support continued appreciation of equities within the eurozone.
Correlations have historically been strong between movements in the EUR/USD exchange rate and the region’s subsequent one-year stock market performance
Euro Stoxx 50 Index year over year vs. EUR/USD exchange rate plus one year. Note that we’ve inverted the exchange rate line to more clearly illustrate the trends in movement. In reality, downward movements in the exchange rate have tended to precede upward movements in stocks, and vice versa.
Elevated eurozone valuations highlight potential risk
While economic indicators, stock market technicals and the tailwind from the weak euro point to potential continued upside in the eurozone, an analysis of equity valuations underscores the potential risks. Using the Euro Stoxx 50 Index, the chart below illustrates the degree to which valuations are being stretched. Regardless of the metric used (and many were reviewed), the nearly 100% run-up in the eurozone since the September 2011 low has resulted in valuations that, despite recent volatility related to the referendum in Greece, are approaching, or have surpassed, decade-long highs.
Eurozone equity valuations are approaching or have surpassed decade-long highs
Euro Stoxx 50 Index estimated price-earnings (PE) and price to cash flow
In addition, since the launch of the EMU’s 60 billion-euro-a-month quantitative easing (QE) program in March 2015, it is instructive to look at the relationship between the Euro Stoxx 50 Index earnings yield relative to the German government 10-year yield to understand the current relative valuation between stocks and bonds in the region. This is shown in the chart below. The current reading reveals that, unlike in the US, eurozone stocks do not appear at this point to be inexpensive relative to bonds, given that the yield spread is near the middle of the range observed since 2005. QE has helped depress German bond yields, but hasn’t thus far resulted in a material difference between the historical relationship between earnings yield and the 10-year German government bond yield. This is due to the fact that stock prices have rallied sharply in recent years, as investors have looked to take advantage of the favorable economic outlook.
Eurozone stocks do not appear inexpensive relative to bonds
Euro Stoxx 50 Index estimated earnings yield relative to German government 10-year bond yields