Unloved European Stocks Poised to Become ‘Pain Trade’ of 2017

  • European equity funds saw outflows of $113 billion last year
  • Gap between U.S., European stock P/E ratios widest since 2009

Investors may be missing bargains among European stocks.

The benchmark Stoxx Europe 600 index is trading close to its cheapest price-to-book value versus U.S. peers in 13 years. Even as earnings in the region are forecast to increase, most investors are pricing in political turmoil. They’re uncomfortable about populism sweeping across swaths of the continent. While that pessimism is reflected in investment outflows, it may be overdone -- turning the market into an overlooked trade.

As U.S. stocks punched through record highs, the benchmark Stoxx Europe 600 Index has struggled to find bulls as this year’s elections in the Netherlands, France, Germany and potentially Italy shape up to be potential flash points. Never mind that the U.K. market jumped after populists drove Brexit to victory in Britain last June.

“The political calendar in Europe is perceived as a sword of Damocles by investors around the world -- it’s sort of an excuse not to be exposed to the region,” Stephane Barbier de la Serre, a strategist at Makor Capital Markets in Geneva, said by phone. “But when you look closely, risks that populist candidates take power are very slim, so people are getting it wrong.”

Many investors who are reluctant to bulk up on Europe lack real conviction and are just following the consensus, Barbier de la Serre said, warning that, if election results turn out to be benign for equities, the region may become the “pain trade” of 2017.

Last year, it was miners. Sentiment toward them was strongly bearish early in the year, during which the Stoxx Europe 600 Basic Resources sector index surged 62 percent, bringing pain to fund managers who had an underweight exposure to the sector.

European stocks have had their Christmas bounce, catching up with Wall Street’s “Trump rally” that was sparked by hopes of greater fiscal spending and tax cuts. On the macro side, a euro area composite Purchasing Managers’ Index climbed to 54.4 in December, showing the strongest economic momentum in more than 5 1/2 years. Still, institutional investors continued to cut their exposure to the region. 

European equity funds suffered outflows in the past 11 straight months, according to data from EPFR Global. Net redemptions totaled $113 billion in 2016, with outflows peaking in mid-2016 and since then dwindling to just $130 million in December.

By contrast, U.S. equity funds, which had also seen outflows for most of the year, enjoyed inflows of $84 billion in the last two months of 2016, as investors poured money into stocks following the U.S. election on expectations of higher economic growth.

European stocks’ valuation ratios relative to the U.S. market bring good trading opportunities in 2017, UBS equity strategists including Karen Olney and Nick Nelson wrote in a note, citing the market’s relatively rich dividend yield of about 3.6 percent and the potential for the gap between U.S. and European price-to-book ratios to tighten.

The S&P 500 traded at 2.95 times book value this month, its highest level since 2007, while the Stoxx 600’s highest level in the new year, 1.86 on Friday, is well below its 2015 high of 2.1 times. The gap between the two markets over the past year has swelled to its widest since 2003.

There’s a similar picture with price-to-earnings ratios. While the S&P 500 trades at about 17.2 times earnings expected in the next 12 months, the Stoxx Europe 600 index trades at 15.2 times expected earnings, well below a peak reached in 2015. The gap between the two began narrowing in November, when it touched its highest level since the financial crisis in 2009.

Among the few contrarian money managers is Pictet Asset Management, which raised its weighting on European equities to “overweight” on Jan. 11, saying the prospects for the region are turning positive and that the risk of immediate political upheaval remains low.

“The euro’s exchange rate is competitive and monetary policy should remain accommodative for the foreseeable future, even with the modest scaling back of the European Central Bank’s liquidity injections in the second half of the year,” Luca Paolini, chief strategist at Pictet AM, wrote in a note.

BlackRock said it turned neutral on European stocks in mid-December from an underweight stance as the weaker euro, signs of global reflation and “ultra-easy” monetary policy from the European Central Bank offset political uncertainties, including Brexit and coming elections.

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