In our view, the recent softness in European earnings and macro data reflect a mid-cycle slowdown rather than the end of the economic recovery in Europe.
The strength of the euro in last year’s third and fourth quarters choked off some of the earnings growth that we might otherwise have expected at the beginning of this year, as around 50% of revenues in European indices are export-driven.
Now, we think renewed US dollar strength should allow Europe’s earnings to recover as we look towards the rest of 2018.
Closer to the End Than the Beginning
Furthermore, our analysis suggests we’re closer to the end of the global economic growth cycle than we are to the beginning. Traditionally, European equities have outperformed in the latter stages of an economic cycle.
It seems to us that a lot of the economic trends that have been evident in the United States in recent years have yet to reach maturity in Europe. As a result, we think it could be time to look at Europe as a means to catch up with other equity markets.
For example, in the United States we’ve seen a restructuring of labour that has fed through to the bottom line of companies, but which is now largely discounted in the stock prices.
By contrast, only now is labour reform in Germany, Spain—and more recently France—allowing core European companies to restructure the labour component of their fixed costs.
The Long Recovery
The global economic recovery began in 2009 and is now the third-longest recovery on record, behind the recessions of 1991 and 1961.
European companies tend to be two to three years behind their US counterparts on the cycle, according to our analysis, so we believe there’s still room for Europe to catch up.
We expect to see some investors who have made money on these themes in the US market start to look for ways of playing those themes in European equities.
We’re in a growth market, and European equities have quite a heavy value skew, so it’s not surprising to us that European equities are taking time to perform relative to the United States.
Entering June, the traditionally value-orientated financial sector made up more than 20% of The MSCI Europe ex UK index , with industrials representing another 15%. By contrast, technology, which is generally considered a growth sector, comprised just 6% of the European index, but more than 25% of MSCI USA .1
Typically “growth” markets, such as this one, have lasted longer than “value” markets. This is not to say that value will continue to underperform, however.
Historically, we’ve often seen a counter-style outperformance in late-stage economic recoveries as the popular stocks run out of steam. In the current cycle, those popular stocks have generally been technology, luxury goods and consumer staples.
We saw this in the last late-cycle recovery—in 2006-2007—when growth outperformed in a value market. We have been building our portfolios for exactly this environment where we typically see higher inflation, higher interest rates and higher volatility.
We continue to find value in European banks and energy companies. This time round, both banks and energy companies are multi-year restructuring stories and still growing their earnings.
Yet the market tends to reward the stocks with valuations at a fraction of technology or consumer staples. European banks, for example, are still some three years behind US banks in terms of restructuring and relative valuations are telling us this.
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1. Source: MSCI. The MSCI Europe ex UK Index captures large- and mid-cap representation across 14 developed markets (DM) countries in Europe. The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the US market. With 631 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future performance. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com.