When thinking about whether Europe has scope to rally further, one can start by taking a look at valuation. The MSCI Europe Index has rallied around 12% this year, in euro terms. On the same basis in US dollar terms, the S&P 500 Index has gained around 15%. Since the end of 2008, European equities have gained over 160%, while US equities have gained in excess of 280%.
Europe remains discounted versus the US
At the end of 2008, the MSCI Europe Index traded on a forward price-earnings ratio (P/E) of around 8x earnings; we are now looking at a forward P/E valuation closer to 15x earnings. For the S&P 500 Index over the same period, the forward P/E valuation has moved from around 9x to over 17x earnings. The two markets have re-rated together and forward P/E valuations in Europe are at a similar discount to those of the US, as witnessed over the past few decades.
It is unlikely that the prospects for both European and US equities over the next nine years are as attractive as they were at the end of 2008, given the huge divergence in valuations between then and now. However, there may be reason for some optimism, even from these high market levels. Europe has had nowhere near the level of margin recovery that has been witnessed in the US; this has left Europe trading at or around multi-decade lows when compared to the US market, in either price-to-book terms, or cycle-adjusted P/E terms (using an average of annual earnings over the last 10 years).
This begs the following questions: how much of this European ‘under-earning’ is structural? And in which areas could Europe see a margin improvement (which could theoretically drive earnings growth and share price performance)?
European under-earnings – a structural curse?
In response to the first question, there are certainly structural reasons why margins in Europe are likely to remain lower than margins in the US for many years to come. For a start, labour laws tend to be far more draconian in certain areas of Europe, France being the most often cited example. This results in inefficient, inflexible cost structures for corporates and suppressed margins. Europe, by nature, is not one unified body but rather a number of socially, economically and politically different nations. As a gross generalisation, this means that companies in Europe tend to be far less able to exploit economies of scale when compared to their US rivals.
In response to the latter question, there are several areas that one could address. Financials is a broad sector where margins and returns have been heavily suppressed by the current low interest rate environment; this is equally true both sides of the Atlantic. However, whereas financials make up over 22% of European indices, they form less than 15% of US indices. As interest rates gradually ‘normalise’ over time, European financials are likely to benefit more than US financials.
Other factors benefit different areas
A similar point can be made for oil and gas; a sector that also forms a larger part of European indices than US indices. The oil price is showing some signs of recovery and, if this continues, European equities are likely to reap the benefit. Elsewhere, telecommunications, air transport and beverages are all sectors where US-focused companies are earning significantly higher margins than their European equivalents. These are sectors where the US market is currently far more consolidated than in Europe. Sector consolidation ‘catch-up’ has been a theme that is likely to continue to drive margin improvement over the next several years in Europe.
Finally, there are sectors in Europe, such as construction, that are still exposed to very depressed end markets, particularly in southern Europe. As economies continue to improve and end markets recover, these sectors will see significant margin expansion that could boost European earnings growth.
It is hard to be ultra-bullish on European equities from a starting point of full headline valuation metrics. However, if we continue to see a decent margin recovery in Europe, this could drive another leg to the current bull market.
James Ross & Tim Stevenson, Janus Henderson Investors
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