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Categorized | Equities

European equities a global laggard on political risk

Posted on November 29, 2016

Donald Trump’s victory in the US elections has delivered a boost to some of the world’s most important equity markets.

All of the major US stock indices hit record highs last week, as optimism over the performance of the US economy gathered pace. In Japan, a weak yen has helped propel the Topix index to its highest level since early January.

It’s a different story entirely for Europe. Its main equities index has gained a paltry 0.2 per cent since the end of October.

The underperformance is particularly confusing given the weakness of the euro, which has fallen nearly 4 per cent in value against the dollar so far in November. Given the fact that 40 per cent of Eurozone sales are made abroad, a weaker euro should be positively reflected in the shares of European companies.

“When the bond yields and the dollar go up, Europe should outperform,” says Mislav Matejka, a strategist at JPMorgan. “It hasn’t happened yet. That’s what we’re highlighting — this underperformance is strange.” The bank also notes that both Eurozone composite PMI data and consumer confidence have hit their best levels this year.

Among investors, there is one resounding answer to the conundrum of persistent European weakness: politics.

“It’s mostly political — that’s the concern we see from investors.” says Martin Todd, a portfolio manager at Hermes Investment Management. “It’s something we’ve been scratching our heads about”.

Unexpected results in the UK referendum on European membership, as well as Trump’s victory in November elections, mean many fund managers are now preoccupied with the threat of future shocks.

Given the weak euro, you would have expected a better performance,” Mr Todd adds. “Global funds have been net sellers for months on end. It’s reflecting these age old concerns about a lack of headline growth in Europe and political uncertainty”.

Flows out of European equities reflect an extremely negative global view towards the asset class. So far this year up to late November there has been a total of $98bn of outflows from European equities, according to data from EPFR on funds it tracks, which shows money leaving the asset class in the vast majority of weeks during 2017.

There is a rising sense among global investors that Europe is going to be difficult to judge, given a packed calendar of potential risks. The Italian referendum on Sunday is the most immediate concern, followed by elections in France in 2017.

Italian banks — which have lost over half of their equity value so far this year — began the week on the defensive over referendum jitters. The continent’s financials have been a crucial part of Europe’s difficulties in 2016, with share prices falling sharply in February. The European sector is down 20 per cent, compared to just 7 per cent for the broader Euro Stoxx 600.

An environment of low interest rates has hampered the banking industry, which, unlike the US sector, is not yet seen as having overcome its crisis travails.

Despite stagnant performance in Europe, equities as an asset class have been less volatile than many other areas of financial markets since the US election.

“The moves in rates, oil, gold and FX are creating rotation within the equity market which mechanically keeps overall index volatility in check as correlation decreases,” says Antonin Jullier, global head of equity trading strategy at Citi. He adds that Trump has “opened a pandora’s box of fiscal easing”.

Any potentially dramatic changes in policy will take time for the market to digest. In a world of rapidly changing political institutions, initial weakness in one regional equity market may not last long.

Not everyone, moreover, is pessimistic on European stocks. Analysts at Morgan Stanley predict that European earnings per share will grow for the first time in five years in 2017, pointing to a moderate recovery in global GDP and a “reflationary theme”.

They also point to European financials as best positioned to outperform, “given the prospect of higher yields, improving earnings, and easier regulation against valuations that remain historically low”.

Others suggest that the aversion to European political risk is overdone. Market-friendly results in the referendum could provide dramatic upside if current prices already reflect expectations of the reforms failing.

“Investors are now shifting to a view that what were previously tail risks should now be seen as base cases … that you should expect the unexpected,” says Mr Matejka. “Our view is: no. Yes we had these surprising outcomes, but we think we’re almost at the peak of uncertainty now.”

And while the continent’s equities have endured huge outflows this year, there have been small inflows in each of the last two weeks, according to EPFR. Investor pessimism may overly rely on the recent memory of historical shocks. If Europe’s political landscape is less chaotic than expected, global flows could provide rapid boosts to the market, especially in monetary policy remains accommodative.

“When we speak to the companies, most of them are just getting on with things,” says Hermes’ Mr Todd. “They talk more optimistically than a lot of market commentators.”