European equities have room to rally

While the escalating US/China trade dispute has increased uncertainty, upgraded expectations for corporate earnings could drive equity prices higher than many foresee.

The strong rally in markets during the first three months of 2019 reversed the trend seen at the end of last year. The US Federal Open Market Committee’s March meeting confirmed that the Fed has moved from mobilising against an inflation overshoot to trying to correct the postglobal financial crisis inflation undershoot. The threat they spoke of in October last year – that the Fed would tighten monetary policy despite a looming recession – has been removed for the remainder of this year, and this is encouraging for all equity markets, including Europe.

The recent inversion of the US yield curve prompted fears it is a recessionary signal, but it might simply be indicating low inflation as nothing else suggests a recession is imminent. Furthermore, the Chinese composite purchasing managers’ index (PMI) has risen, as has Chinese credit formation, and retail sales have improved in Asia as a whole. Similarly, in Europe the services elements of PMIs have improved, as have retail sales.

It’s true that some economic indicators signal caution. Notably, global trade is contracting – and seems set to shrink further due to poor US/China relations and the imposition of tariffs by both sides. This escalation caused a correction in global equity markets on 14 May – the day that China announced retaliatory tariffs in defiance of President Trump. The lagged effect of tightening monetary policy means that OECD leading indicators are still negative, as are manufacturing PMIs in three of the world’s four biggest economies (the US, China, Japan and Germany). [1]

Even so, the key measures of long bond yields, corporate yield spreads, oil prices and US dollar strength are not flashing red. Fixed income yields are too low to act as a brake on the economy, and oil prices at $70 a barrel [2] are close to their 10-year average. We are not seeing a repeat of 2008 when both the oil price and the US dollar spiked. If it is simply a temporary slowdown, then the yield curve should steepen again.

EUROPEAN BANKS VERSUS US TECH

So where does that leave European equities? Their performance compared with the US is often correlated to the euro/ US dollar exchange rate. Relative earnings growth of Europe compared with the US is driven by the underlying strength of their economies, evidenced by the PMIs. As relative earnings growth and relative PMIs have stopped falling, Europe looks better for now. Though the sensitivity of US equities to fluctuations in economic growth has recently increased, it is still much higher in Europe, which should therefore benefit from stronger global growth.

The problem for Europe is that its banking sector remains large and faces huge challenges. Loan growth is anaemic, banks lack capital and the sector is fragmented – especially compared to the US.

For Europe to outperform, European banks must outperform US technology. Investors face a choice between three large European banks (Santander, BNP and ING) and three large US tech companies (Apple, Microsoft and Alphabet/Google). The second largest single sector (until recently the largest) in Europe is banks, while the largest US sector by far is technology. [3] There is a chance that Europe’s banks might see a share price recovery, but thanks to negative interest rates, reliance on ECB funding, aggressive regulation and fragmentation in the sector, any outperformance will be short-lived.

Will Europe follow Japan? Japanese financial sector profits peaked in 1990 and are now half that level. After a credit bubble has burst, borrowers lose their appetite for borrowing, which is fundamental to banking. Bank profits depend on leverage (the amount of equity they need to hold to back their loan books), regulation and net interest margins. In all these regards European banks are facing terrible headwinds. Harsher regulation might hobble US technology too, but right now it is European banks that are suffering. If the yield curve were to steepen (because of expected higher inflation) in the second half of this year, will this not drive European financials (and cyclical stocks) higher?

Meanwhile, European bank valuations, judged on a relative price/earnings ratio basis, are close to their lowest since the financial crisis. [4] Italian non-performing loans are collapsing as a share of total loans. Italian banks are being cleaned up or sold. Spain started earlier, but it is a similar story. There should be another leg of improvement to come. The insurance sector, meanwhile, has outperformed the fall in bond yields and now looks relatively expensive.

At the same time, European domestic demand should be boosted by looser fiscal policy, which should add 0.6% to GDP, and lower bond yields. [5] The latter will help Italy most of all. The spike in Italian yields last year was caused by the election of a populist government that delighted in inflammatory rhetoric, plunging the country into recession. Now that Italian government bond yields have fallen 100 basis points from their highs, [6] the loosening in financial conditions should help the economy improve.

CAN MARKETS RALLY FURTHER?

Almost everything that caused the sell-off in late 2018 is now moving in the opposite direction: both the stronger dollar and the US slowdown into the federal government shutdown are reversing. US 10-year Treasury yields are down from 3.2% in October last year to 2.5% now. [7] The Fed has stopped tightening.

That said, the intensifying US/China trade dispute introduces uncertainty and a headwind to global growth. Europe benefits from rising global growth, but suffers equally when it slows or contracts.

Assuming trade tensions do not derail global growth, the trend of corporate earnings revisions must reverse and show an improvement. Earnings upgrades could drive equity prices higher, even after the 20% rally from the bottom reached last December. [8]

Looking back to 2016, equity markets started to rally in February, despite earnings revisions remaining negative for the whole of that year. Markets can go a long way even when earnings growth is being cut. If earnings bounce, the rally can continue. Many are targeting an end-ofeconomic cycle peak of 3,000 on the S&P 500 Index. The trade dispute may disrupt the S&P 500’s rally in the short term, but prospects are strong for the longer term.