European equities have performed poorly this year. Weak manufacturing purchasing managers’ indices were a significant factor that led to the slide in markets across Europe. We believe that the decline does not yet provide a clear buy signal, even if pockets of value and interesting opportunities at the company level have emerged.
European equities lost ground in spite of rising earnings expectations. Decelerating growth in manufacturing and the change of government in Italy contributed to a large extent. As of November 21, the Euro Stoxx 50 had fallen 8 percent in 2018 while the MSCI UK index lost only 4.5 percent — despite tense Brexit negotiations — and the more resilient Swiss market index (SMI) shed only 3 percent. The export-oriented German DAX index plummeted 14 percent, while financial stability concerns triggered a drop of 13 percent and 10 percent in the Italian and Spanish markets respectively.
The MSCI Europe index traded on a P/E multiple of 12.7, which represents a substantial decline from a peak of 15.3 in January 2018. Investors eager to buy European equities should remember that the MSCI Europe index traded on a P/E multiple of about 9 during the 2011-12 euro debt crisis. While we do not forecast the situation in Italy to escalate to such an extent, it is likely that the Italian government will play a game of brinkmanship with the European Commission until European parliamentary elections in May 2019.
A further deceleration in European growth also appears likely. With the Euro Stoxx 50 trading on a P/E multiple of 12.3, the German DAX on 11.7, the French CAC 40 on 12.3 and Spain on 11.3, we do not think that these markets offer rock-bottom valuations which would provide a sufficient margin of safety. Only Italy, with a P/E multiple of 10.3, looks cheap.
British equities (MSCI UK) traded on a P/E multiple of 11.7 – a stark decline from their peak of 16 in 2015. Domestically-focused UK companies, in particular, trade at steep discounts and, in several cases, offer interesting investment opportunities. This applies more to investors who anticipate a favorable Brexit outcome, which is our base case. Swiss equities traded on a P/E ratio of 16, after a peak of 17.5 in May 2017. We think that a 9 percent multiple compression would offer a genuine bargain.
While we did not find truly low-valued equity indices at the country level, some sectors and industries offer value, including energy, mining companies, banks, insurance companies and the automobile industry. Automobile companies stand out most visibly with a P/E ratio of 6.2, which prices in many potential negative developments, structural issues and the need to invest massively in electric vehicle production.
European banks traded on 0.7 times their book value, a significant discount given generally decent earnings and broadly adequate capital bases. Italy wields a Damocles sword over the industry, so we seek attractively priced elements in banks’ capital structures (e.g. AT1 bonds). Among the more expensive sectors, we flag IT and industrials, which traded on elevated multiples and would be at risk of multiple compressions should European economic growth decelerate further.
We conducted an ultimate stress test of valuations by calculating the implied equity risk premium for European country and sector indices.
According to our calculations, UK and German equities look most attractive on a long-term basis. Few European sectors offer really attractive risk premiums. Consumer discretionary stocks, including automobiles, belong to this group, followed by materials and, at a distance, insurance and banks. We conclude that European equity valuations ‒ with clear exceptions such as automobiles ‒ do not appear extremely low and that the ongoing cyclical slowdown still harbors risks going forward, as analysts currently keep revising earnings expectations downward.
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