This article was written by Matthew Dennis, senior portfolio manager for Invesco international/global growth products.
On the back of strong European Central Bank (ECB) quantitative easing measures and increasing signs of successful reflation, the eurozone continued on a trajectory of improving trends that the Invesco International and Global Growth team cited early in 2015, when most observers had a negative outlook on Europe. Viewed through our earnings, quality and valuation (EQV) lens, Europe offered investors generally positive news and some compelling opportunities for long-term investors.
Earnings: Positive quarter and outlook
Tangible evidence of reflation in eurozone activity indicators, credit and the euro exchange rate were all constructive for growth and inflation during the quarter. These factors underpinned revenue and earnings estimates on an absolute basis — and certainly relative to some weaker areas around the world. Specifically, ECB-driven money supply expansion and purchasing managers’ indexes point to stronger growth, not just for now, but also in coming quarters.
Today, valuations are vulnerable to increased volatility and anything disruptive to current growth expectations. And the jury is still out on global growth.
These trends are constructive for earnings in the region:
- Deflationary risks have moderated, with core inflation trends in the eurozone rising, a critical change given the deflation scares that have plagued Europe for some time.
- Eurozone consumer confidence is close to eight-year highs,1 while retail sales volumes are back at pre-crisis levels.2
- Corporate bond yields are signaling further tailwinds in terms of lower borrowing costs.
Regarding actual growth rates, 2015 earnings growth expectations for the UK are expected to be essentially flat, held back by heavy resource sector weightings. In contrast, eurozone growth expectations are intriguing, with an anticipated recovery in the low teens anticipated in 2015, exceeding estimates for the US, Japan and most emerging markets, excluding India.3 Support from the weak euro was enough to drive earnings revisions into positive territory in April, May, and June.
The euro’s weakness has provided a release valve to stimulate growth relative to stronger currency markets, a trend we anticipated at the beginning of the year. It’s taken a little while for us to find opportunities, given valuations during the first quarter, but volatility in the second quarter has allowed us to move modestly in that direction. Cyclical areas, such as European banks and financial exchanges, benefited from increased volatility and activity, as did asset gatherers such as UBS (1.72%, 1.93% and 0.94% of Invesco International Growth Fund, Invesco European Growth Fund and Invesco Global Growth Fund, as of June 30, 2015).
Our thesis on UBS, the world’s largest truly global asset manager, has continued to progress nicely in the two and half years since we purchased the shares. Earnings (E) growth has been buoyed by declining restructuring costs as the bank downsizes its lower-return investment banking division in favor of a shift toward wealth management, which generated higher returns on equity. In addition, management’s decision to deleverage the balance sheet supported the quality (Q) component of our framework, while valuation (V) has rerated while we’ve owned the stock but remains underpinned by management’s decision to return excess capital to shareholders via a 50% payout commitment.
Quality: Cyclical opportunities
Given our high-quality bias, our portfolio returns tend to lag at inflection points in the economic cycle and during periods of very strong and speculative markets where pure momentum or low-quality, high-beta names outperform. Both circumstances are evident year-to-date, in our view, and may very well persist through 2015.
If Europe’s recovery gains traction without disruption, our portfolios with exposure to Europe will likely underperform. But if eurozone growth falters or volatility spikes — not just in Europe, but globally — our strategies have potential to outperform. But there’s an exception: Our strategies with greater small-cap exposure, such as smaller European companies, European growth or Asia Pacific growth, may get a boost from small caps’ potential to outperform during the early phases of a recovery.
Most of the opportunities we saw in Europe during the second quarter were cyclical. We were able to take advantage of the volatility, adding exposure modestly, particularly in bank stocks, where it made sense from an EQV fundamental perspective.
Valuation: Recovery priced in
The valuation challenge in Europe is that multiples have already anticipated earnings recovery in most instances. The MSCI Europe Index’s 12-month forward price-earnings ratio (P/E) is close to its post-2002 high,3 and Europe’s median forward P/E multiple is close to a record high.3 Constructively, normalized European valuations and book multiples looked less extended. At the sector level, the highest relative valuation discount across Europe was in the energy sector.
Cyclical stocks looked cheaper than defensive stocks, but because valuation opportunities clustered toward the lower-quality end of the cyclical spectrum, we found no opportunities there. More recently, fundamentals have lured us toward European transport, business services and, as mentioned, banks.
Today, valuations are vulnerable to increased volatility and anything disruptive to current growth expectations. And the jury is still out on global growth — my blog post Volatility and growth: Two critical questions for international markets explores how these two factors affect the verdict.
As always, we remain committed to creating long-term value for our investors by muting market noise to focus on quality growth fundamentals.