Forget what could go wrong for Europe. What could go right?
With elections and referendums on the agenda across Europe this year, concerns linger that the European Union (EU) could plunge into chaos as a wave of populism and Eurosceptic forces sweep the continent
However, Stephen Macklow-Smith, Portfolio Manager for the J.P. Morgan European Investment Trusts, argues that many of the looming problems are, in fact, overblown, and takes a closer look at why the continent is likely to remain resilient in 2017.
Elections and referendums are being held this year in four of the six founder members of the European project. Decades of liberal world order, multiculturalism and open immigration could fall to right-wing parties if victories for Le Pen’s Front National or the German ‘Alternative for Germany’ (AfD) spark Brexit-style referendums.
It could be the end of centrism as we know it. Or not. But, what if 2017 actually goes right for Europe? In fact, what if it’s already better than we think? And what would it mean for investors if it was?
Let’s take a look at five reasons why the picture for Europe could be more positive than many think.
1 – Extremist party wins may be low-or even non-existent
Drawing a pattern from the UK referendum and the US presidential election, it’s been fashionable to call for extremist party wins in the Netherlands in April, France in May and Germany in September. Less conveniently for the popular imagination, the polls in Europe show that:
- Even if the Party for Freedom (PVV) wins in the Netherlands, it will struggle to form a government
- Marine Le Pen may do well in the first round, but she will be defeated comfortably in the second
- Merkel will be forming another coalition in September. Far from ending the year with three populist governments, we may well end with none
2 – The numbers are healthier than you might think
Inflation is recovering, so nominal growth is picking up. Company revenues are a nominal rather than a real measure, so the relief in pricing pressure is good for margins and earnings.
We are already seeing analysts upgrading forecasts, global growth is improving and global purchasing managers’ indices are above the level at which further earnings upgrades are triggered.
Even if analysts don’t change their numbers, we believe earnings will grow this year, and on a price-to-book basis Europe is as cheap vs. the US as it ever gets.
If we assume that earnings rise in line with analyst estimates of approximately 8%, and that the valuation does not change, then investors would get the growth in earnings plus the starting dividend yield of approximately 3%.
That translates into a respectable low double-digit total return on Europe.
3 – 70% of the population is actually in work
As another reason to defy the pessimists, look at the story behind the continent’s moribund and much-derided unemployment numbers.
A source of consternation and perceived sign of stagnation, the official statistics mask a much more nuanced picture.
In fact, European employment is within touching distance of its previous, pre-crisis high of 70%. In other words, 70% of the population is in work (the other 30% being retirees, children, students or unemployed).
This good news is masked by the fact that unemployment is at a structurally elevated 10% (although that has been falling steadily since 2013).
The reason why employment is at a high, but unemployment is not at a low, is that the participation rate (i.e. the percentage of the population that has enrolled in the workforce) has been rising steadily.
This reflects a number of factors, such as women returning to the workforce (possibly helped by easier and more flexible childcare) as well as fewer people taking early retirement.
Overall, a higher participation rate contributes to better productivity, and the fact that the European participation rate has been rising signals the success of a number of government initiatives to try and improve the dynamism of Europe.
4 – Unusual return-on-equity headwinds are set to die down this year
Return on equity is much lower in Europe, but we all know the reasons why: bank write-offs coupled with dilutive share issuance, energy earnings smashed by the oil price, commodities earnings hit by metals prices in 2015, emerging market earnings (for instance in luxury goods and food & beverages) depressed by downturns in commodity-dependent economies, autos earnings hit by Dieselgate. Yet all of these factors are set to either moderate or turn into tailwinds in 2017.
5 – Political risk isn’t all bad
Even Brexit could be viewed in a positive limelight for the EU. One could argue the UK’s decision to exit the EU is actually a positive for the European project, in that it removes an impediment to further integration, since the UK has always vetoed federalist initiatives. In addition, the UK has been the largest single recipient of foreign direct investment in the EU in the last 10 years. If access to the single market is impeded, at least some of that investment may well flow to the continent.
Put another way, not all political risk is bad, particularly when there’s an opportunity for positive change. For European investors, finding viable opportunities to generate returns will require looking through the mixed headlines and ferreting out the facts. The fact is that a pick-up in corporate earnings, incomes and economic growth is within reach, and that could well filter through to the ballot box. Asking what could go right for Europe this year is not nearly as naïve as you might think.
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