17.07.2017 | 13:39

Janus Henderson: Is Europe just joining the party?

For international investors who see Europe as a highly taxed retirement home, the first half of 2017 has been a surprise. In a period of strong improvements from many equity markets, some of the best returns have come from Europe (with the MSCI Europe Index up 13.1% for the six-month period, in US dollar terms). Of course, Europe has not solved all its long-standing problems, such as low growth, an ageing population, high regulation and taxes and complex labour codes.

Rather, European equities have responded to the waning threat from populist politicians who, at the start of the year, had been threatening the future of the euro and who have since been pushed into retreat at the polls in Austria, the Netherlands and more recently in France. At the same time, the political backdrop in two other developed economies has deteriorated significantly: in the US the Trump administration has found it difficult to implement its ideas in tax, healthcare and infrastructure. The outlook for the UK has also clearly dimmed as a result of the arguments about how to implement Brexit.

A few sweeteners for voters
In this new context, Europe looks like a rich developed economic area with investment opportunities and problems not dissimilar to those elsewhere – so why should its equities trade at a discount? In a few months, the view of France has changed from a country facing insuperable problems under tired, discredited politicians to one where Emmanuel Macron, a young centrist reformer, has a strong electoral mandate for change. Implementing reform will be far from easy, but the greater the chaos in the UK, the easier it will be for Macron to push through changes – the alternative path now looks so unappealing. In an unexpected and bizarre development, disillusioned UK voters now wish they had their own Macron.

Further economic encouragement is likely to come from Germany. Preserving the current structure of the euro is hugely beneficial to German economic interests, although this is not widely acknowledged. Even though the euro has strengthened against the dollar in the past year, it still provides Germany with a much more competitive exporting currency than it would have without the euro. Hence it will find a way to support economic reforms in France and perhaps Italy too. These ‘bonbons’ are unlikely to be offered before the German election in September but should emerge later.

Clear signals for investors?
While the view of Europe has changed sharply in the last few months, I have been arguing for some time that the best European companies are not looking at the newspapers and groaning. For many years they have been focused on their operations and opportunities; and some investors realised this well before the French election. But given the strong performance of equities in recent months, is this now the end of the party?

The signals are mixed. In the US the new car market is softening, although employment growth remains robust. But in Europe several major economies such as France and Italy are only now emerging after years of near permafrost. Construction is still recovering from very low levels. There is plenty of room for activity and employment to pick up. Germany is stronger than ever. Surveys of economic confidence continue to rise. So arguably it is domestic plays on construction or other labour-intensive local services that might benefit from labour-market reform and/or infrastructure programmes.

In France, infrastructure and construction group Eiffage should benefit from new government contracts to extend the motorway network and to ease congestion in cities, particularly Paris. There is also potential work from the Summer Olympics in 2024, with Paris facing Los Angeles in the final stage of the bidding process. In a different sector, contract caterer Elior would benefit from the simplification of the French labour code, which famously is longer than the Bible. More use of flexible labour contracts would boost growth and profits.

Another supporting argument has come from the first-quarter reporting season, with many European companies reporting robust profits growth (and on some surveys, stronger profit growth than in the US where corporate earnings were held back by the impact of the stronger US dollar).

The risk of ‘normalisation’
But there is one cloud hanging over equities. How will the end of quantitative easing (QE) play out and how will it affect the valuation of all assets? In the last week of June, bond and equity markets took a tumble following remarks from European Central Bank (ECB) head Mario Draghi, which were taken to mean that the end of QE (central bank bond-buying) was close at hand. The yield on 10-year German government bonds (‘bunds’) shot up from 0.25% to 0.47% in a few days. Subsequent statements from the ECB seemed to suggest nearly the opposite. Central banks around the world are trying to find a way to normalise interest rates at a time of recovering economic activity at a time when underlying inflation and real wage growth remains low.

Clearly the US central bank has taken the initiative on starting to increase interest rates. But the ECB has to tread much more warily because it does not want to snuff out what is a fragile recovery. A combination of a strengthening euro and higher borrowing costs might be hard to handle for some European economies – and the euro is already at its highest level in a year against the US dollar. Higher interest rates would likely squeeze disposable incomes. So a more realistic scenario is for the ECB to move very slowly in unwinding QE (‘normalisation’) and making any decision on raising interest rates. That means a relatively benign backdrop for European equities. In addition, Draghi is acutely familiar with the problems in Italy, where serious reforms have yet to start. Italy may have faded from view in recent weeks, apart from a deal to fix two of its troubled banks, but with high debts, the country cannot afford higher interest rates. Draghi is unlikely to want to be remembered as the man who brought down one of Europe’s largest economies.