Our Insights

About personal finance, investments and markets.
July 1, 2014

European equities: what’s hot, what’s not?

The MSCI Europe forward P/E multiple is currently at 14.5x, the highest in more than 10 years. All the equity gains this year have again come from P/E multiple expansion as earnings growth was nearly flat. European equity markets are not cheap anymore on an absolute level. Should investors therefore abandon equities entirely? We think it is prudent to take some profits but investors should not cut the equity allocation to zero. Rather than looking at the whole market, we think investors need to dig a little deeper and we try to show where we can still find value.

JPM MSCI Europe at 12y high

The rerating of equities is not implying complacency over growth
The bulk of the multiple expansion in the European equity market was due to the rerating of the defensive sectors – which are treated as bond proxies in our view. This includes telecoms, utilities, staples and healthcare which have all rerated versus their 10 year median P/E more than the overall market has. On the other hand, cyclical stocks have undershot the multiple expansion seen over the past years. Put differently, we believe the high current market P/E multiple is not pricing in much optimism with regards to the growth outlook but is a reflection of the search for yield.

 12m forward P/ECurrent vs 10y medianContribution to market re-rating
MSCI Europe14.519%100%
= Cyclicals15.116%23%
= Defensives17.432%50%

As the table shows, the market (MSCI Europe) has rerated by 19% over the last 10 years. 50% of the rerating is due to defensives and only 23% is due to cyclicals (the remainder by energy and financials). This is indicates to us that the market rerating was driven by the yield compression in the defensive sectors.

We believe the European equity market P/E multiple can still move further up, but the composition of the rerating should be changing. If the global growth accelerates to above trend pace in the second half as we expect and becomes more synchronized, then the cyclical sectors should drive the bulk of the next rerating phase.

The outperformance of the defensive sectors relative to the cyclical sectors is not a European phenomenon. Due to the low interest rates on the back of the aggressive monetary policy of the major central banks, we have wittnessed a chase for yield that has gone beyond bonds and subsequently drove up the price for assets that are perceived as proxy carry-trades.

BoA global defensives vs cyclicals

Equities have rerated less than credit and government bonds
The rerating of the equity market seen over the last few years has occurred against the backdrop of broad based asset reflation. Relative to fixed income, European equities still look attractively valued. We can compare equities against European investment-grade credit and German government bonds by using the inverse value of their respective yields as a P/E proxy (yes, there are lots of caveats as these different asset classes have a different duration but we think it is still a worthwhile analysis). German government bonds and Eurozone investment grade credit have rerated by 180% and 270% respectively since the lows in early 2009. This compares with a 140% increase in Eurozone equities trailing P/E and with a 100% increase in Eurozone equities „dividend“ P/E.

JPM MSCI Europe vs fixed income

Summary: Are you an absolute or a relative return investor?
In mid 2014, it is not possible to make the argument that European equities are cheap on an absolute basis. However, what we can say is that cyclical stocks are relatively more attractive than the overall equity market and that the overall equity market is relatively more attractive than credit and government bonds. We certainly wish there would be a better argument to buy than”there’s no alternative”… but that is just not the case at the moment. We invest accordingly.

We said it before: we are in a late-stage bull market, and as value investors, this is a tough environment for us. There is absolutely no question that we struggle when other investors are willing to pay a silly premium for characteristics that they deem as attractive and which we don’t. History is on our side: high valuation leads to poor future returns. Particularly income producing assets like defensive stocks look very stretched to us. If investors want to cut their equity exposure, this could be a good place to start. So just remember, nobody ever got fired for taking too much profit!

Investors need to avoid home-bias. There are still equity markets that trade at lower multiples than Europe or the US and which also trade below their historical 10 year average. We will soon publish a comment in our „investment strategy“ section on this topic. If you would like to discuss how to structure a global portfolio, please don’t hesitate to get in touch with us now.

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