Is it time to bet on European equities?

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The embattled eurozone is a stranger to good news these days but some remain hopeful that a long-overdue return to growth could happen the second half of the year and potential returns await investors prepared to take the plunge.

To say economic conditions in the eurozone remain challenging would be an understatement. During the first three months of the year, the region notched up its sixth consecutive quarter of negative growth.

The continued economic contraction has left to one in four across Spain and Greece without a job. Unemployment recently hit a new high when Eurostat, the data arm of the European Commission, found the number of people seeking work in the beleaguered region smashed through the 19m mark in April – a leap of almost 100,000 people from March.

After the European Central Bank today kept interest rates on hold as expected, Capital Economics senior European economist Jennifer McKeown believes the bank is likely to keep a cautiously open mind to both further rate cuts and measures. 

Schroders’ European economist Azad Zangana forecasts a return to growth, albeit very weak growth, in the second half of the year. However, he says: “The risks to this part of the forecast are to the downside at the moment given the lack of improvement in business surveys.”

Purchasing manager index data released from across the eurozone earlier this week pointed to a significant reduction in the rate of decline in the manufacturing sector in the month of May.

Many of the key countries in the region including Spain, Italy, France, Germany and even Greece saw significant improvement in factory activity, moving to multi-year high levels and beating consensus estimates. Notably, Greece is currently holding a US-based conference in a bid to convince investors to return to the battered nation, with officials urging “the worst is behind us”.

But many eurozone banks remain at risk of further capital calls. Against this backdrop, there is potential for further bouts of risk aversion and resultant weakness in European equity markets.

However, Killik & Co head of research Mick Gilligan says: “This information is well flagged and should already be factored into investors’ positioning and decision-making, and therefore also into the pricing of equities.”

From a stockmarket perspective, returns have been perhaps not as bad as some may imagine, given that a plethora of European firms derive much of their revenues from outside the region. Year to date the MSCI Europe (ex-UK) index is up 13 per cent but for its part the FTSE 100, despite its recent run, has trailed, firming 11 per cent. Over five years, the gap widens, with indices up eight and 29 per cent respectively, and over three years, the Footsie has put on 39 per cent against the MSCI’s 32 per cent.

“With sentiment particularly weak, sustained indications of the slowing of the post-financial crisis de-leveraging process, credit growth turning positive and a bottoming of the inventory cycle could have a large impact on equity valuations as investors price in a more optimistic outlook for the region,” adds Gilligan.

One of the key drivers of asset prices in the short term is the money creation as a result of central bank action around the globe. Gilliagn forecasts that this policy action will probably remain a determinant of equity market direction in the near term.

He says: “The recent move by the ECB, to cut interest rates from 0.75 per cent to 0.5 per cent, moves us closer to zero interest rates in the eurozone. A change in tone from Germany’s government, with recent reports suggesting that fiscal stimulus could be considered, may signal a key inflection point for the region.”

Killik & Co has just upgraded its recommendation for the Argonaut European Income fund from neutral to buy. The fund aims to provide an income in excess of the yield of the MSCI Europe ex UK index, whilst preserving capital, by investing primarily in the shares of quoted continental European companies, or companies that derive a significant part of their business from continental Europe.

Gilligan notes that the fund’s stock selection has been consistently strong in the last three calendar years. The fund has been overweight financials, which was a particularly weak sector in 2010 and 2011, and remains the fund’s biggest overweight sector position, the bulk of which is gained via insurance companies.

“The fund continues to be positioned in those quality companies capable of generating and sustaining healthy dividends, whilst being less sensitive than the wider market to economic weakness. Companies that are able to deliver profits growth and distribute part of this to investors in a progressive manner should continue to see their share prices move higher,” adds Gilligan.

The European Assets investment trust could offer another attractive way to play a potential recovery in Europe, the brokerage firm says. It presently trades on an 8 per cent discount to NAV and should things brighten up for the region, investors could expect that to narrow.

Another investment trust, TR European Growth, trades on the widest discount in the listed sector at 17 per cent. Approximately 70 per cent of the portfolio is typically invested in core holdings – targeting companies with a high return on capital employed, structural growth characteristics and the ability to perform through the cycle. The remaining 30 per cent is used for shorter term, opportunistic, deep value ideas, Gilligan notes.