On 3 December 2015, the European Central bank (ECB) announced further monetary easing policies as it sought to counter the downside risks facing the Eurozone economy. Further cutting the deposit facility rate by 10 bps to -0.3%, an extension of its asset purchases programme to at least March 2017, indefinite reinvestment of maturing principal and a widening of the range of securities it can buy to include local and regional government debt.
ECB President Mario Draghi announced the expanded stimulus measures, as he sought to spur inflation back towards the ECB's goal of "close to but under 2%". Upon announcement of the expanded stimulus measures, global equity markets tanked as markets were expecting more aggressive measures, particularly an increase in the amount of assets being purchased on a monthly basis (currently EUR 60 billion). European equities fell by –3.14% (in local currency terms, as measured by the Stoxx 600) and the EURUSD currency pair soared 3.07% to mark its best day since March 2009 as overly negative positioning by investors on the EURUSD on great expectations for very aggressive easing were left disappointed and positions were unwound.
While markets were initially disappointed by the expanded stimulus and press conference, at a speech in New York on Friday 4 December 2015, Draghi's remarks that "QE was here to stay" amongst others helped to stabilise equities.
Chart 1: European Equities Drop
Chart 2: EURUSD Rebounds
From our point of view, the latest expanded stimulus measures are a positive for the Eurozone economy, particularly given the efficacy of the previous measures which have seen borrowing rates decline in both the core and periphery of Europe, with lending surveys and credit growth starting to pick up speed to the upside.
The Underlying Economy
Recent leading indicators have pointed to a steady recovery in the Eurozone, with sentiment readings as well as Purchasing Manager Indices continuing to indicate an economy that is in expansionary mode (Charts 3 and 4). In addition, as mentioned above, credit conditions in Europe have improved thanks to the previous measures undertaken by the ECB, with lending rates having fallen by "more than 80 basis points for the Euro area as a whole, and by between 110-140 basis points in stressed economies" since June 2014, a trend that can be seen in Chart 5 as well as in the improvements in the lending surveys (Chart 6 and 7).
Chart 3: PMIs Still Expanding
Chart 4: Sentiment Indicators Remain Firm
Chart 5: Lending Rates On The Decline
Chart 6: Banks Easing Credit Standards
Chart 7: Loan Demand Still Increasing
The recently published 3Q 2015 GDP figures reinforce the above, with private consumption being the key driver of the recovery currently on-going in the Eurozone. As for the other components of GDP, although corporate investment has yet to return in a big manner given the amount of output slack, reduced fiscal austerity should continue to reduce the drag from government expenditure (as was the case over the past few years) and an improvement in the emerging markets (particularly China) should help net exports overcome their current deficit.
Chart 8: Eurozone Economy Expanding
All in all, the Eurozone economy seems to be on a path of gradual recovery and is expected to contribute more to global economic growth moving ahead in to 2016.
With an improving economy, earnings growth in Europe are also expected to post relatively decent rates of growth, with consensus estimating growth rates of 7% and 12% in 2016 and 2017 respectively, with earnings growth for domestic-oriented companies amongst the strongest. We note that the tendency for European earnings to be gradually revised down through the course of the year has been diminishing since 2014 and through 2015 (apart from the downgrades seen in August and September 2015 stemming mainly from worries over Chinese growth) as seen in Chart 9 as the economy has stabilised and continued its modest recovery.
Chart 9: Earnings Forecasts
While the ECB's expanded stimulus measures and the Eurozone's underlying recovery are signs of stronger economic growth ahead, European equities are by no means cheap based on current valuations. Whether one chooses to use a price-to-earnings valuation method which sees the continent trade at 15.0X PE based on 2016 or 13.5X 2017 earnings as compared to their estimated fair value of 13.5X earnings, or a price-to-book measure which sees the continent valued at 1.87X PB which is on par compared to its long-term average of 1.87X, gaining exposure to European equities does not come at a discount at all and in fact, comes at a premium based on 2015's PE of 16.1X. Looking at the expected total returns by end 2017, the valuation multiple raises a red flag as it projects an annualised contraction of –11.0% over the course of the next 2 years, largely erasing the returns that are expected to be driven by earnings growth and dividends.
Chart 10: Valuations Are Not Cheap (PE)
Chart 11: Valuations Are Not Cheap (PB)
Chart 12: Beware The Valuation Multiple Contraction
We retain our 2.5 Star "Neutral" rating on Europe given that markets have appeared to have priced in many a positive and have perhaps put the cart before the horse. We advise investors invested to underweight the region while taking profits along the way should European equities continue their rise (and get more expensive) and reinvest the said profits into more attractive regions such as Asia ex Japan equities which trade at a discount to their estimated fair value. As for investors seeking to gain exposure to the region, we believe a dollar cost averaging approach should be given due consideration as it would allow one to average in at lower prices should the projected annualised contraction of the valuation multiple play out.
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