As markets heave a sigh of relief at Geert Wilders' defeat in the Dutch election, political uncertainty persists as attention shifts to France. But we see bright prospects for equities as the economic backdrop improves.
The results from the Dutch election show that Prime Minister Mark Rutte’s People’s Party for Freedom and Democracy (VVD) has won the most parliamentary seats. This avoids the threat of the anti-immigration Freedom Party (PVV) gaining power led by Geert Wilders. A coalition government will now be negotiated in the coming months, led by the current prime minister.
The strong support for the current VVD government should be taken as a positive outcome for European markets, with the country turning against the more populist measures proposed by the PVV. This included the risk of a potential exit from the European Union (EU), euro and greater restrictions on immigration, all of which could have resulted in a significant increase in risk aversion across European equity markets.
Although the market had been relaxed about the outcome of the Dutch election and the risk of the PVV gaining power, ongoing political uncertainty is a key risk we've been highlighting for Europe this year. Investors are concerned about upcoming elections, in particular for the largest eurozone economies France and Germany which go to the polls in April/May and September.
After the recent Brexit referendum in the UK, and the election of the Donald Trump administration in the US, the increasing risk of more populist governments gaining power in Europe has been a concern. The future of the EU and the stability of the euro were perceived to be potentially at stake. Although we see the risk of this as low, this uncertainty is likely to persist until the outcomes of these elections are known.
The market should take some confidence from the outcome of the Dutch election, as it's the first sign that mainland European economies may turn against the political parties with more anti-EU policies.
Encouragingly the election saw very high turn-out at around 80%, with the majority vote clearly favouring mainstream political ideology. We will see how the other elections play out, but this result could reflect a stronger European economy i.e. greater optimism around personal circumstances. It also shows that centre-right political parties are willing to take a more robust approach towards immigration which appeases more of the popular vote.
Putting aside the political uncertainty, we believe there are strong arguments to be positive on the outlook for European equities. The cyclical recovery across Europe is clearly gaining momentum, with lead indicators remaining positive and signs of improving confidence amongst corporates and consumers. Eurozone unemployment continues to fall, supporting the recovery being seen by the domestic consumer, which in turn should lead to a greater willingness of corporates to raise investment.
This is being aided by easier borrowing conditions for corporates and households, helped by a European banking system which is finally becoming better capitalised and willing to extend credit. The threat of deflation also appears to have been avoided, with inflation now approaching the European Central Bank’s (ECB) 2% target.
Along with a healthier domestic environment, the global backdrop is also supportive for European exports. Growth in the US economy continues to look robust, helped by the more growth-friendly agenda promoted by the Trump administration.
China has started the year with good economic momentum, with a combination of economic stimulus and environmental reform also contributing to the improving outlook for global commodity prices. There are also signs that other emerging market economies such as Brazil and Russia are slowly turning a corner after several challenging years.
For European equities, this strengthening economic backdrop is finally translating into improving earnings prospects. In 2017 expectations are for high single digit earnings growth, with further improvement in 2018.
This follows several years of moderate or no growth, which has been one of the key reasons for the material underperformance of European equities versus the US. European corporates have been suffering from the recent deflationary environment, the limited recovery in domestic demand, and a general lack of pricing power.
With earnings expectations now being revised up, there are signs these issues are now slowly reversing. The weaker euro is also helping corporates stay internationally competitive, especially versus the US dollar.
Given the recovery potential for profit margins and earnings, valuations in Europe look compelling, especially when compared to other developed markets such as the US. The European market is trading on 15x price-to-earnings rate and a 3.5% dividend yield, with profit margins still depressed in many of the more cyclical sectors. On our favoured valuation metric - the cyclically-adjusted price-to-earnings ratio - the market offers 40% upside to its long-term average.
We have been looking to take advantage of the recent political uncertainty and resulting volatility, by adding to holdings where we believe the market has been too slow in reacting to the potential for earnings to recover.
We have also been taking profits in some of the more defensive sectors, many of which have been driving the market higher this year. It is interesting to note that despite the improving economic indicators, value has actually been underperforming growth so far this year. This likely reflects the caution in the market and concerns around the upcoming elections.
We have been finding attractive value opportunities in the materials sector, for example, with returns for some companies potentially set to improve substantially as demand recovers and overcapacity concerns are addressed.
We also see opportunities in the consumer discretionary sector, where companies look poised to benefit from the domestic recovery underway in Europe, as well as the improvement being seen in emerging markets.
The far right Party for Freedom (PVV), led by Geert Wilders, has been comprehensively defeated by incumbents the People’s Party for Freedom and Democracy (VVD), with leader Mark Rutte now set to lead as prime minister for a third term. The PVV, which had campaigned on an anti-EU, anti-immigrant ticket, had led in opinion polls for the best part of the last year and only slipped behind the VVD in the last two weeks. However, the results show that while the PVV has gained seats, it has significantly underperformed expectations, and only barely finished as the second largest party.
Rutte will now commence work to form a coalition government, but this will not be a straight-forward task. The Labour Party (PvdA), which was the previous junior coalition partner, has suffered a severe loss in seats, and so the VVD will have to form a broader coalition, perhaps with three or more parties. This is not unusual as the Dutch parliament has always been fragmented (with 13 parties winning seats this election). The election results will come as a relief for investors as it is the first notable underperformance of a populist party for some time. Given the Dutch constitution rules, Wilders probably would not have been able to gather enough support to actually hold a binding referendum to leave the EU, but notwithstanding this, the results are a positive surprise.
Investors will now turn their attention to the upcoming French presidential election, which arguably has a lower probability to disappoint, but could have bigger consequences for the EU should Marine Le Pen’s Front National win. Le Pen’s party has the most support of any single party, but the two stage electoral system in France means that top two candidates face each other in a run-off. This is when Le Pen is then expected to lose by quite some margin, regardless of whether she faces Francois Fillon or Emmanuel Macron (the next two leading candidates).
Of course, opinion polls have been less reliable of late, and so investors are likely to remain cautious on Europe until political risk dies down.