Time to buy European equities

First, I admit to having been a bull on European equities for the last couple of years. This was right at the beginning of last year, but since then there has not been much progress, and lately we have seen a major slide back to the middle of the ranges seen in recent years.

Looked at in isolation, European equities are not hugely attractive by historic standards. The Eurostoxx 50 has a P/E close to long-term averages at 15 and a dividend yield that is only modestly attractive at 2.5%. Dividend growth has been conspicuous by its absence since the financial crisis. But you can’t look at these things in isolation. The attractiveness of European equities has to be compared to other assets, and in the context of the current condition of the European and global economy.

The main reasons for optimism about European equities are their relatively attractive valuation compared to other major equity markets, the extremely low level of European bond yields, the comparative health of the European economy (and the prospect of decent co-ordinated global growth for the first time in a while), and the relative insulation of the Eurozone from any protectionist pressures from the US, both because they are not particularly directed at Europe and because the size of the Eurozone economy means it is less dependent on external trade than smaller countries.

While European bond yields have risen a little from the lows alongside US yields, they remain very, very low by historic standards. The chart of the French 10-year yield below illustrates this.

The French 10-year is a reasonable proxy for European yields as a whole. While we have probably seen the lows, as the economy is now growing reasonably robustly, inflation has probably bottomed and the ECB has stopped easing, the ECB are not about to raise rate any time soon. This makes European equities look particularly attractive, as they yield more than bonds but should also rise with any rise in nominal GDP.

The combination of low European yields and a stagnant equity market suggests the equity risk premium in Europe is very, very high, and this is hard to justify given the improving fundamental economic conditions. Europe is nothing like as expensive as the US, with European indices now only in the middle of the range seen in recent years, while the US has continued to make multi-year highs. The chart below shows the Eurostoxx 50 relative to the S&P 500 rebased to 2003 so that they are comparable.

On a P/E basis, the Eurostoxx 50 is trading around 15 compared to 22 for the S&P 500, and yielding 2.5%. The underperformance of Eurostoxx in recent years is in large part  due to the lack of dividend growth compared to the strength of dividend growth in other markets. However, European corporate profits are rising and are above where they were at the peak of the market in 2007, suggesting dividend growth will come, while exceptionally low yields mean the discount factor for future dividends makes them all the more attractive.

Currently, the market is concerned about trade wars and the prospect of tightening financial conditions, especially in the US, especially in the context of extended US valuations. European markets have also tended to suffer from EUR strength against the USD, though in reality there is not much evidence that this has a negative effect on European company profits.

The impact on import prices and the global nature of many companies means exchange rate moves do not have clear implications.  In practice, it is hard to be too positive about the US market at these levels given rising US rates, so there is a case for partially hedging a long Eurostoxx position with an S&P short. But there should nevertheless be substantial upside for European equities from here.