We maintain a preference for European equities, although valuations aren’t as cheap as they were a year ago, with peripheral credit spreads tight and equity PEs having expanded. However, we believe that the elevated PEs are somewhat misleading given Europe has only recently emerged from recession. Moreover, with earnings growth starting to emerge, we believe the case for rotating from European credit towards European equity risk exists for investors in Europe.
Within equities, the elevated PE ratios lead us to focus on positive earnings momentum opportunities within Europe. While the emergence from recession is certainly a contributor to the nascent earnings recovery, we are also beginning to see corporate margins beginning to expand, albeit from a low base.
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Geographically, this earnings recovery favours Italy and Spain relative to "core" European economies such as Germany. From a style perspective, we expect the outperformance of growth stocks relative to value opportunities in Europe to reverse given the significant discount at which value stocks trade, while they also deliver yields of near 4%, effectively paying investors to wait.
Moving into 2014 we expected improving momentum on the fiscal front and sustained policy accommodation from the ECB to support European bond markets. We expected these two factors combined with improving corporate fundamentals to drive the positive performance of European bonds relative to other government bond and credit markets. They have done so and as bond yields have fallen we have gradually been reducing the scale of aggregate bond positions in the region in favour of equities. In doing so, we have however also been rebalancing portfolios to re-emphasise government debt and high-yield bonds.
For the last few years the focus of our strategy has been on the middle of the quality spectrum in European investment-grade corporate bonds. The debt of blue-chip firms offered access to low or falling interest rates plus an additional level of yield (‘spread’) for the extra credit risk. With default rates falling, corporate leverage declining and earnings rising, the return outweighed the risk and so investment-grade credit spreads declined. They are now less than half what they were at the start of 2011. This now diminishes the attractiveness of the sector both on an absolute basis and relative to other sectors including government bonds and equities.
On the one hand, faster economic growth and increasing momentum in deleveraging on the sovereign side is reducing country risk, particularly in the periphery of Europe. This makes the yield on government bonds more attractive because the risks are lower. On the other hand, because we believe firmer growth prospects should support equities, we have also complemented a higher allocation in government bonds with allocations to high yield as we think the same factors should prove supportive for the debt of medium-sized companies and the lower-rated debt of large financial institutions.
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By GlobalDataNoman Villamin, CIO Coutts Europe
