Leaning in to Headwinds and Headlines
There’s been no shortage of headlines focused on European volatility lately, and the current consensus is that Europe is the last place investors want to put money. The risk for investors in my mind, however, is that they follow the headlines and exit Europe now instead of leaning into the headwinds of consensus and building positions.
Focus on earnings
As always, we are bottom-up stock pickers who evaluate and invest in companies based on their underlying earnings, quality and valuation (EQV) fundamentals. Right now, visibility on the earnings front is the greatest challenge. The weak euro and the decline in the price of oil — which has reduced inflation expectations and, in turn, lowered pricing power expectations in a lot of businesses — are feeding concerns around earnings. Despite some modest signs of stabilization in European earnings revisions, they’re split between still-extensive downgrades in the energy, metals and mining space and upgrades for the companies that make their earnings in US dollars. Stabilization in earnings growth expectations remains a critical pillar for market performance in Europe.
At some point, however, some of these negatives will start to turn positive. For example, even though Europe has higher fuel taxes than the US, lower energy costs should ultimately start to stimulate consumption as people have more money to spend.
Weaker euro could stimulate growth
In late January, the euro was trading below 116 to the US dollar — down about 8% from the end of the third quarter of 2014 and about 15% from the 136 or so level last summer.1 Although it will take time for the impact of the decline to filter through the euro area, consider this: If the euro were to remain at this point, we expect that it could provide high single-digit uplift to year-over-year earnings starting in the current quarter.
Notably, the consensus for European earnings expectations currently align with the consensus for global and international market earnings growth, as well as for the S&P 500 Index, all of which peg 2015 earnings growth expectations at approximately 10% to 11%.2 The scope for better operating leverage from slightly better growth in the next two or three years, coupled with a weaker currency already starting to feed European earnings expectations, is a notable positive that should ultimately feed higher equity prices.
Impact of QE
On Jan. 22, the European Central Bank announced a quantitative easing (QE) program. It stands to reason that implementing QE will prove more difficult in Europe than in the US simply because of the number of cooks in the kitchen. But I don’t think the assumption that QE can’t work there is rational. The critical questions are:
- The duration and commitment to QE in Europe.
- Whether QE will be complemented by fiscal policy that actually puts dollars into the economy to stimulate activity, as opposed to simply providing liquidity and credit to the economy.
But QE will have an impact, in my view. It will, at least, form the basis of a monetary policy that seeks to stabilize yields and keep credit costs down, and it could possibly drive up prices in the equity market.
Overestimating or underestimating?
Here’s the overriding question in our minds: Will the market have overestimated or underestimated European earnings growth when we get to the end of 2015?
The negatives about European assets have been well publicized. But let me suggest that investors consider two things:
- First, the idea that GDP trends are correlated with market performance is absolute bunk. As mentioned, a weaker euro is in the early stages of planting the seeds for a better growth outlook. That’s clearly not a consensus expectation, but there’s no reason not to expect it to be priced into expectations before it’s fact.
- Second, recall that in 2013, Europe was the place for investors to be. Notably, European performance was disappointing in the following 12 months. As you know, current consensus is that Europe is the last place investors should be. Consider the pattern: History has proved time and again that following the headlines can be risky for investors.
To summarize, while the short-term outlook for European assets is negative, I believe long-term investors should consider how today’s negatives could evolve into longer-term positives. Talking to their advisors about leaning into the negative consensus — which is often wrong — may help them use the current weakness to potential future advantage.
1 Source: Bloomberg L.P., Jan. 16, 2015
2 Source: Invesco, FactSet, January 2015
The S&P 500 Index is an unmanaged index considered representative of the US stock market.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Many countries in the European Union are susceptible to high economic risks associated with high levels of debt, notably due to investments in sovereign debts of European countries such as Greece, Italy and Spain.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
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