We’re seeing signs that the recovery in Europe is progressing. I wanted to take a moment to highlight some of the positives, uncertainties and opportunities that we believe investors should consider about the region:
• First, Europe appears to be past the worst of the fiscal retrenchment drag on growth. Leading economic indicators are trending up, including purchasing managers’ indexes (PMIs) and retail sales. Effectively, this second derivative of growth is positive, not just in the US, but in Europe as well.
• Secondly, credit spreads in Europe are easing, particularly in such countries as Spain and Italy, whose spreads are at their best levels in years.
• And thirdly, consensus European earnings growth expectations of +13% to 14% for the coming year look healthy compared to consensus earnings expectations of +10% for the US.1
Lastly, European Central Bank (ECB) policy is likely to remain simulative in 2014 given the lack of inflation and the need for the ECB to err on the more conservative side regarding monetary policy ahead of incremental bank stress test and restructuring initiatives.
Other positives for Europe include:
• Surveys suggesting that there’s increased willingness to lend by Euro-area banks, as well as evidence indicating that loan demand is bottoming out.
• Data confirming that corporate balance sheets are healthy. It’s been a steady theme, but we’re now at a point in Europe where net debt-to-equity levels are near 15-year lows, with positive implications for capital expenditures (CAPX) should business confidence indicators start improving.1
Uncertainties
There are also uncertainties to consider when investing in Europe, including:
Healthy credit creation remains far from guaranteed. The ECB and bank regulators are currently assessing the quality of Eurozone bank balance sheets, and incremental write-downs and further provisions are likely to emerge. In the near term, this could lead to more selective (reduced) lending to higher risk small- and medium-sized enterprises (SMEs), which drive much of the core European growth.
Valuations are no longer outright cheap. The European forward market multiple of 13.6x is constructive on a relative basis compared to the US, but it needs to be recognized that we are now approaching the upper end of the 10-year historical range. 1 This may be a signal that the recovery that is anticipated in 2014 is just beginning to be priced in, and therefore, valuations are more dependent at this point on that pickup or follow-through in terms of earnings and cash flows.
The Wildcards
As we look to the rest of 2014, there are a couple of trends in terms of wildcards that you should be aware of and that we’re certainly focused on:
• The first, and probably most important, is the possibility that European capital spending expectations could be exceeded in 2014. In theory, there’s a strong correlation between earnings growth and capital spending, with earnings tending to lead capital spending, which then drives higher out-year earnings growth expectations. Current consensus Eurozone earnings expectations of 13% to 14%, combined with the fact that organic capital spend and M&A levels in Europe are at 20-year lows bode well for an increase in corporate spend.
• The second wildcard I would highlight is the constructive spreads and low cost of financing currently available in Europe. There is a chance that volatility and credit spreads may or may not stay low. If they stay low, multiples can expand and we can get incremental returns. If credit spreads were to expand, multiples would likely compress – it’s a real simple relationship.
• The last wildcard I’d like to highlight is the challenge facing the ECB with respect to the banking sector. The emergence and sustainability of positive credit creation dynamics as part of the European recovery are linked to effective ECB political negotiation and candor regarding outstanding European bank restructuring needs. If they are too lenient in their assessment of the health of Europe’s still bloated banking sector, they risk loss of credibility. If they are too harsh, they risk political backlash and further inertia in reaching compromise that is effective.
Opportunities
We select stocks after stringent evaluation of three company characteristics: earnings, quality and valuation (EQV). In this environment, we see real opportunities in the following areas:
Financials
We see particular opportunity in the Financials sector, not just in Europe, but globally as well. In Europe, we have added several names to the Invesco International Growth Fund over the last year, including UK-based global investment management group, Aberdeen Asset Management PLC, and UBS, the global financial services company headquartered in Switzerland (1.22% and 0.61% holdings, respectively, of Invesco International Growth Fund as of Dec. 31, 2013).
By design, our additions remain outside the European wholesale banking sector, which remains volatile and subject to further restructuring. Our focus is on well capitalized, high return on capital franchises.
Capital goods
We also see opportunity in specific capital goods firms that we believe are reasonably priced and well-positioned to benefit from any acceleration in capital investment. Names in the Invesco International Growth Fund that could benefit from this trend include automation/electrical equipment manufacturer ABB, and Swedish-based global communications network company, Ericsson (1.49% and 0.71% holdings, respectively, of Invesco International Growth Fund as of Dec. 31, 2013).
Media/Advertising
Because their valuations remain attractive on an absolute basis, we believe media companies and ad agencies, such as WPP and Publics, are attractive because they stand to benefit if growth expectations for Europe and the globe are proven to be conservative (1.97% and 1.86% holdings, respectively, of Invesco International Growth Fund as of Dec. 31, 2013).
Energy
The energy sector is another area where we have been active over the last year, based primarily on the sector’s inexpensive valuations and its scope for recovery in the event of an improvement in global growth and industrial production.
1 Source: Bloomberg L.P.
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