In Europe, sentiment improving but more work lies ahead
February 19, 2015
European equities are at (or near) historical highs. In the following Q&A, investment specialist Margaret MacCarthy Bacon looks at prospects for the European economy and outlines her views on the implications for equity markets.
Do you think the euro zone’s economy is hitting a legitimate inflection point?
While the euro zone continues to face headwinds, the economic environment appears to be improving. This is reflected in the region’s latest reading for the Purchasing Managers’ Index, which increased to 53.5 in February from 52.6 in January (an index value greater than 50 indicates business activity is expanding). Further signs of rebounding economic health include:
- The employment picture is gradually strengthening, with unemployment having peaked at 10.2% in mid-2013 and slowly decreasing to 9.5% today.
- Consensus estimates indicate that earnings growth is expected to continue getting better.
- As a whole, the European economy is expected to post roughly 1.3% growth in 2015 (according to estimates published by the International Monetary Fund). This comes on the heels of two consecutive years of no real economic expansion.
Although we do not make macroeconomic calls in relation to the portfolios we manage, we currently have overweight positions in Europe and should therefore stand to benefit from a recovery in the region.
Are worries lessening about Europe’s political and economic landscape? Is it too early to say?
This is a two-part answer, because we see two sides of the coin here. There are signs of increased confidence, but there are also reasons to remain cautious.
Stock market returns, for example, are implying that investors do seem more optimistic. The MSCI Europe Index, for instance, has gained 4.70% in 2015 through Feb. 19; compare that to the MSCI U.S. Index, which advanced by 2.16% during the same period. In part, these equity gains have been supported by developments such as lower oil prices, a weaker euro, and the European Central Bank’s (the ECB’s) planned stimulus program.
Although we believe the ECB’s quantitative easing program is a significant step in the right direction, we think additional structural reforms are needed in many euro-zone countries. These reforms include better flexibility in labor markets, synchronized taxation among countries, and fewer regulatory burdens for companies. There are also other valid concerns for investors to keep in mind, including the conflict in Russia and Ukraine, Greece’s inability to pay its debt, slowing economic growth in China, and geopolitical tensions in the Mideast.
The German stock market has posted a series of record closes thus far in 2015. What should we be reading into those gains, if anything? Do your strategies take positions in German names?
It is almost impossible to predict where the German market will trend in the near term, but we believe current momentum is benefiting from the same factors that are influencing broader gains across Europe at large: (1) lower oil prices, which benefit consumers as well as businesses, (2) the weaker euro, which helps German exporters, and (3) the ECB’s plan to carry out quantitative easing.
Another point worth remembering is that Germany is the largest economy in the euro zone and has been reaping the rewards of the structural reforms it implemented more than 10 years ago. These reforms include fiscal austerity, lower taxes, restructured unemployment benefits, and simplified labor laws.
Regarding your question about our German holdings: Our portfolio decisions are never predicated on macro conditions; they are driven by company-specific analysis. As such, our international equity portfolio currently has positions in two German companies that we think are attractively valued:
The first is a pharmaceutical company based in Germany that specializes in the production of generic and over-the-counter (OTC) drugs. The company’s primary growth drivers are continued economic growth in Eastern Europe, continued growth of the branded/OTC business, and stabilization of the European generics business through higher utilization rates. The company’s high-single-digit free-cash-flow yield should also give it some flexibility within its capital structure.
The second is one of the world’s largest providers of mail, express-delivery, and logistics services. It is Germany’s primary mail operator, with more than 80% market share. The company also operates an industry-leading global express business, a freight forwarding business (the largest globally), and a supply chain management business (likewise the largest globally). We believe the company's management team has done a good job restructuring the company and cutting costs. The company is benefiting from favorable foreign exchange and lower fuel costs, and it offers a dividend yield that we find attractive.
The views expressed represent the Manager's assessment of the market environment as of February 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
The Purchasing Managers’ Index, published by Markit Group, is an indicator of the economic health of the manufacturing sector.
The MSCI Europe Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the developed markets in Europe. The MSCI Europe Index consists of the following 15 developed market country indices: Austria, Belgium, Denmark, Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.
The MSCI U.S. Broad Market Index represents the universe of companies in the U.S. equity market, including large-, mid-, small-, and micro-cap companies. This index targets for inclusion 99.5% of the capitalization of the U.S. equity market.
Index performance returns do not reflect any management fees, transaction costs, or expenses. Indices are unmanaged and one cannot invest directly in an index.
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IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Past performance does not guarantee future results.
International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.