NNIP keeps equity on neutral, raises taxations

The European equity market performed strongly in the first half of the year, with the MSCI Europe Index up 16.6%, despite multiple headwinds caused by escalating trade tensions, faltering economic growth, declining earnings expectations and domestic political challenges. What can we expect for the second half of the year?

Maarten Geerdink

From NN Investment Partners’ (NN IP) perspective, the picture for European corporate earnings is bottoming out. Momentum has strongly improved and our full-year earnings growth projection has also ticked up from 4.4% in early June to 4.7% today. The outlook for corporate margins remains uncertain; they have recovered nicely but are showing signs of fatigue. Revenue growth is the most important driver of these margins as it offsets rising commodity prices and wages. In this respect, a better macro outlook and greater corporate pricing power are needed. Fortunately, the latest Purchasing Manager Index (PMI) data for Europe are encouraging and the domestic side of the economy remains resilient. However, Europe is also sensitive to global trade developments, given its export dependence, and this weakens its pricing power, which has driven central banks to step up their dovish efforts.

Monetary policy and earnings stabilisation are key to equity performance

NN IP is also closely monitoring monetary policy. In June, both the ECB and Federal Reserve hinted at potential interest-rate cuts starting in July. For European equities, this is something of a double-edged sword, as a lower-for-longer rate environment is a headwind for the financial sector, which represents 18% of the index. As a “value” market, Europe performs best when the global growth outlook is improving and yields rise. Nevertheless, these insurance rate cuts are necessary to combat the rising secular stagnation fears that have had Japan in their grip for many years and that have pushed equity risk premiums to high levels, i.e. 7.6% in Japan compared with 6.8% in Europe.

Earnings stabilisation and easy monetary policy are crucial valuation drivers. In absolute terms, with a trailing price-to-earnings (PE) ratio of around 15, the European market is trading at a 12% discount to its long-term average. Relative to global equities, this discount is close to 15%. In the past 20 years, a discount this high has occurred only during recession periods. So, barring a recession, sluggish data already appears priced in. The combination of a better earnings outlook and more dovish central banks could put a floor under valuations or even push them up. Finally, investor positioning is light in Europe, which is supportive for the market. The uncertainty caused by trade and internal politics has taken a toll on sentiment and risk appetite, with investors focusing primarily on defensive sectors and bond proxies rather than more growth-oriented, cyclical sectors. This implies that if the economy gains steam, there is still upside potential in these segments, which represent 62% of the market including financials (44% excluding financials).

Green shoots hint at upside for cyclicals but we stay balanced for now

“Within our European Dividend strategies, we currently retain a balanced positioning in terms of cyclical versus defensives, as we would require confirmation of improved economic conditions before becoming more cyclically exposed,” commented Maarten Geerdink, Head of European Equities. “Within the defensive space, we shy away from the very expensive luxury and consumer durables stocks and bond proxies (food producers and regulated utilities) and focus on the more attractively priced segments within defensives, such as certain consumer staples (food retailer Ahold Delhaize [1]) and pharmaceutical firms (Roche and Sanofi). In the cyclical sectors, we see opportunities in higher-quality names with turnaround potential. We think high-quality firms such as Siemens, Prysmian, Covestro and CRH should benefit from better macro conditions but are also driven by improving company-specific elements that can unlock value.”

Overall investor sentiment is far from exuberant, but it will probably require increased clarity on political risks (Italy and Brexit could linger on for several months) and macro data to confirm the recent green shoots. If these green shoots become more apparent in the coming months, we would see a lot of promise in growth-oriented cyclicals such as industrials or materials. Further fiscal stimulus in Europe would be a big positive surprise and act as an additional catalyst to boost markets.