The Case for Europe – Myths vs. Reality


Why Europe Now?

  • Current stretch of European underperformance is unprecedented both in length and magnitude
  • Earnings recovery is coming back very strongly and Europe’s operational leverage is vastly underappreciated
  • Discount to the US has never been this wide (39% vs. 24% average)
  • Macro data is still near two decade highs and indicates robust economic growth
  • CAPEX boom expected: Europe running close to peak capacity
  • Support for the euro remains very strong and it’s actually increasing in Italy
  • Significant outflows from the region tend to be a good contrarian indicator
  • There are impressive technology growth stories in Europe, they are just not captured by the index

Myth: Europe always underperforms the US

Reality: Not true historically and the current stretch of underperformance is unprecedented

  • Europe and US have moved in lockstep for decades and the stretch of significant European underperformance since the 2008 crisis is highly atypical
  • Even if include the crisis, in dollar terms, European equities outperformed the S&P 500 in 8 out of the last 15 calendar years
  • During years of outperformance, Europe is on average 13% ahead of the US

Myth: European earnings are not growing as fast as the rest of the world

Reality: No longer true and the operational leverage of the region remains underappreciated

  • Earnings argument is valid but backward looking. Single biggest reason for underperformance has been the lack of earnings recovery
  • From the bottom of the crisis, US equities returned 290%, whereas Europe is only up 115%. During the same time, European earnings doubled while US almost quadrupled
  • European earnings are still below pre-crisis levels, while the US is nearly 90% higher and the rest of the world also grew 33%
  • Analyst consensus now expects European EPS to grow at a similar rate to the rest of the developed world, at around 10% in 2019
  • Historic data and current operational leverage implies a 6x earnings multiplier on GDP growth, which should result in EPS growth closer to 15%

Myth: Europe is always trading at a discount to the US

Reality: Yes, but the current discount is well above average and close to the widest on record

  • Investors are aware that Europe is trading at a discount to the US, and the usual reaction is that the US valuation premium is justified given higher growth, higher margins and better ROE
  • Finding it very hard to explain why Europe is trading close to the deepest historic discount, while earnings are expected to grow at the same pace as the US and the margin and ROE gaps are actually narrower than their long-term averages
  • As soon as operational leverage starts showing in Europe next year, a significant valuation rerating can take place
  • A rerating to the average historic discount alone would offer 50% upside from current levels

Myth: The recovery in European economies is running out of steam

Reality: Macro data still near two decade highs and supportive of robust growth

  • The only thing that has slowed is the rate of change, and while growth is no longer accelerating, the most recent readings of PMIs, retail sales, industrial production, credit growth, unemployment, and the European Commission’s broader economic sentiment indicators all point to robust GDP growth for the next 24 months
  • Consumer confidence remains at a two decade high and as we see no reason why the market should not rerate to a level implied by the consumer’s bullish outlook

Myth: Capex remains muted – European CEOs are concerned about the outlook

Reality: Capacity utilization is nearing peak levels and there’s strong pent-up demand from a decade of underinvestment

  • Reason we believe that spending will pick up in the next 12 months is that many industries are now close to full capacity
  • Tight labor markets and increasing automation are also supportive of Capex boom
  • We think we are at the beginning of a multi-year spending cycle that should add further support to the already robust economic growth on the continent

Myth: Outflows are a leading indicator of poor performance

Reality: The 5 largest streaks of outflows were followed by positive returns outside 2008

  • Second largest outflow streak on record behind 2016, when $100bn was pulled from Europe over 38 weeks
  • Outside the financial crisis in 2008, the 5 largest streaks of outflows were followed by strong positive returns over the next 12 months

Myth: Italy is on the verge of leaving the euro and causing the collapse of the currency union

Reality: Support for the euro has increased in Italy and there’s room for macro surprises

  • Support for the common currency has strengthened over the last few years
  • Italians also understand that their own savings, overwhelmingly in euro denominated debt products, would be at huge risk should they abandon the common currency
  • Populist shift in Italy does not present real systemic risk, and some of the more unorthodox proposals of the government could even offer a much needed boost to the stagnant Italian economy
  • Core features of the government’s program are tax cuts and a universal income for Italy’s poorest households, both of which have the potential to lift Italian economic activity in the near term

S. W. Mitchell Capital: The Case for Europe – Myths vs. Reality, August 2018

Image Source: S. W. Mitchell Capital, Datastream, IBES