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Categorized | Equities

Returning inflows raise hopes for European stocks


Posted on November 8, 2016

As faint glimmers of optimism go, the first week of November did at least offer Europe’s stock market investors something: after 39 weeks of relentless outflows of money, €83m returned, according to data provider EPFR.

In the year of Brexit and Trumpism — which began with market turmoil as the oil price collapsed and threatens to finish with another destabilising vote, this time on Italy’s constitution in December — the news was perhaps easy to miss.

It also comes after investors had pulled €110bn from European shares between February and October, according to EPFR. US investors in particular have withdrawn this year, selling €36bn of European Exchange traded funds, according to UBS.

Still, might the inflow herald a shift, a change in the direction for European stock markets which have fallen between 3 per cent (Germany) and 22 per cent (Italy) this year?

After all, turning points in the market tend to come when large numbers of investors are yet to be persuaded the danger has passed.

“It’s hard to overstate, when you’re talking to international clients, what a challenge politics is to get over,” says Rob Griffiths, equity strategist for Credit Suisse. “There are a number of components to this positive Europe story but they just get washed away.”

For instance, opinion polls suggest Matteo Renzi, Italy’s prime minister, faces a battle to win approval for changes to the electoral system which underpin a broader effort to pass economic reforms. If defeat is followed by political and market turbulence, the country’s banks may struggle to raise enough capital from shareholders to address piles of problem loans.

However, Mr Griffiths describes these problems as well known, when compared with the complacency in some markets ahead of the UK vote to leave the EU in June. Spain has also demonstrated how an almost year-long political vacuum without a formal government does not have to impact the economy. The case he makes to those clients is based in large part on an optimism about Europe’s banks, businesses whose prospects are intertwined with its economy and stock markets.

About 9 per cent of the value of European stock indices resides in what he calls pure banks, almost double the amount for the US. Europe’s banks also play a larger role in financing economic activity than in the US, where companies have greater access to capital markets. The sector has been hit this year as bond yields collapsed worldwide, making it hard to lend profitably, but in the last month benchmark borrowing costs have started to rebound.

“You have a European economy, and European market in hock to the banks. So when yields go up, Europe outperforms,” says Mr Griffiths.

Investors scarred by market violence may require more persuasion to return, with trading volumes also pointing to a withdrawal. Bats Europe, the region’s largest stock exchange, says average daily notional value on European markets between July and September fell 20 per cent, to €39bn.

Virtu Financial, one of the world’s largest electronic market makers, also reports that a post-Brexit surge in trading activity petered out. In the last quarter its average adjusted net trading income for European equities was $128m, down 46 per cent compared with the same period a year ago.

“Market volumes were muted and realised volatility has been at historic lows, reducing the opportunity for a market maker to earn spread,” said Doug Cifu, chief executive.

Asked to explain the withdrawal, the head of electronic trading and sales at one midsized European bank says: “It’s so, so difficult to tell. So much risk has been taken off the market in the uncertainty. The hedge funds have had a bad year — with a few notable exceptions — the high-frequency traders and market makers feed off that, so there’s an ever-decreasing circle of liquidity.”

Another reason may be a now familiar story of dashed expectations when it comes to corporate profits. A year ago the consensus of investment bank analysts was for aggregate earnings to rise in 2016, but for the sixth year running they have instead declined.

Nick Nelson, UBS strategist, is in the camp of optimists who think Europe’s listed companies will not face a seventh lean year. “It’s a combination of factors — commodity prices, interest rates, inflation,” he says.

If the oil price remains stable, with Opec meeting this month in Vienna to discuss production cuts, it should be easier for miners and energy companies to make money next year, both in Europe and the emerging markets where many European companies also operate.

Higher bond yields, or even just the possibility of higher interest rates, will help the banks. Inflation above zero might allow manufacturers and retailers to raise prices. Hence some tentative confidence, and investor money, returning.

“Europe does appear to be cheap, but you only think it’s too cheap if the earnings are going to appear,” says Mr Nelson.