Ask any investor in Europe what concerns them most, and election risk will likely be near the top of the list. With French elections underway,German elections looming, and the fallout from the U.K.’s Brexit vote ongoing, that concern is to be expected. However, the Invesco International and Global Growth team believes that election risk – while real – may be overstated. Looking through our EQV (Earnings, Quality and Valuation) lens, we believe that valuations in the highest-quality companies are expensive, but we have been opportunistic in finding new names that are seeing short-term dislocations.
Elections take centre stage in France and Germany
In France, Emmanuel Macron, leader of the centrist En Marche! party has won the French presidential election, however, his party at this time has no seats in the French National Assembly. Marine Le Pen’s far-right National Front party has only two of the 577 seats in the French National Assembly. So despite winning the presidential election, president-elect Macron has a lot of work to do ahead of the June legislative election and is unlikely to win a majority in the Assembly. Either way markets and proponents of the European Union are happy he won.
Meanwhile, the German election on Sept. 24 is looking more and more like a non-event as citizens appear to be tiring of anti-EU sentiment and populism, and might prefer to stay the course with longtime Chancellor Angela Merkel. That would be positive for markets, in our view.
In the U.K., we favour multinationals
The outlook for U.K. large-cap equities is looking more positive, in our view. The U.K. equity market was recently trading at a relatively subdued valuation of about 14x its forward price-to-earnings (P/E) ratio, versus the rest of Europe at about 15x and the US at 18x.1
After the Brexit vote, the consensus expectation was for a U.K. recession in 2017, but so far that view has been wrong. We are somewhat concerned about slowing consumer spending and a low savings ratio, so at best we expect stable growth in the U.K. economy for the rest of the year.
As of March 31, 2017, our strategies were overweight in the U.K. versus their benchmarks. To put that in perspective, we are geared to multinational companies that earn the bulk of their profits from their international business – for example, blue chip British American Tobacco PLC, food caterer Compass Group PLC and information solution provider RELX PLC (respectively, 1.56%, 1.35% and 1.74% of Invesco International Growth Class, and 1.94%, 1.51% and 2.69% of Invesco European Growth Class as at March 31, 2017). These companies share similar attributes of attractive organic revenue growth along with pricing power, expanding margins and strong cash conversion and returns, in our view.
A weak pound is beneficial for exporters and multinationals. While the currency recently strengthened when U.K. Prime Minister Theresa May called a snap election for June 8, it is still the most inexpensive since 1988 based on purchasing power parity versus the U.S. dollar. With difficult Brexit negotiations to come over the next two years, we expect the currency to be volatile.
Value in Continental Europe
The picture in Continental Europe is healthier than in the U.K., in our view. New orders, measured by the Purchasing Managers Index, have recently been consistent with 3% gross domestic product growth, while the consensus expectation for 2017 is around 1.7%.2 We have seen consistent macro surprises come out of the EU in the last couple of quarters, and low-single-digit 12-month consensus earnings upgrades for all sectors except health care.
With Europe trading around a 16% to 17% discount to the U.S. on forward P/E, and a 54% discount on Shiller P/E versus its own 15-year average of 29%, we continue to see value in Europe – but less so in expensive high-quality sectors such as consumer staples, where P/E ratios of 22x to 25x are now the norm.3
Financials sector improvement in Europe
There are three main reasons why we believe the European financials sector is more attractive today than in the past:
- We are seeing signs that top-line pressures have receded: loan growth for banks, premium growth for insurance companies and net new money for wealth management firms. The possibility that quantitative easing could taper down in the second half of 2017 is positive for net interest margins
- Regulatory headwinds have forced companies in the financials sector to beef up capital levels and meet strict stress tests. Those issues seem largely behind us
- Valuations remain attractive with P/E around 10x to 11x and a price-to-book ratio of 1x.4 In the U.K., Lloyds Banking Group PLC (1.10% of Invesco International Growth Class and 0.77% of Invesco European Growth Class as of March 31, 2017) reported strong first-quarter earnings and raised its targets for net interest margins, capital generation and provisions. We would still want to see signs of improving return on equity to increase our weights in European banks
In Europe in the first quarter, our strategies trimmed some exposure to consumer discretionary and media companies, as we have seen some potential headwinds in these areas.
We initiated a position in Italian bank Intesa Sanpaolo S.p.A. (0.70% of Invesco International Growth Class and 0.72% of Invesco European Growth Class as of March 31, 2017). We believe it is “the best house in a bad neighborhood,” and we like the fact that it is strongly capitalized, pays an attractive dividend of 6.5%,4 and is seeing a sequential improvement in nonperforming loans. We bought it in February 2017 at 0.85x tangible book value and less than 10x forward earnings.