Does Europe warrant inclusion in portfolios yet? Mona Shah, assistant manager on Rathbones' multi-asset portfolios, examines the fundamentals.
Allocating to Europe remains an uneasy endeavour. Global deleveraging and economic dispersion between EU member states have pushed the Maastricht framework to breaking point. Furthermore, we have seen the bond markets force the hands of policymakers’ due to the latter’s inertia.
By way of comparison, despite some questions around US growth rates, investors remain less anxious about that economy, primarily because the authorities took early action to resolve the crisis, and the banks constitute a smaller percentage of GDP than in Europe.
The market also understands that the debt-carrying capacity of the dollar, per unit of GDP, is higher than other currencies. There is, of course, another key reason – the US is an established federal state. Sadly, the EU remains, for many, an “experiment”. Investors, it would seem, are right to be cautious.
Last year, European markets rallied but they remain about 6% below highs seen in October 2007. On closer inspection, European earnings and dividends have not progressed sufficiently, suggesting the momentum was predicated less on fundamentals and more on positive sentiment on the back of the ECB’s Outright Monetary Transactions programme.
This has been reflected in the fact that a stronger euro has not halted equity gains, as it may have done historically, due to a belief that the currency has a future based on such measures.
Furthermore, although some inflation convergence has been achieved, it has not boosted intra-regional trade nor has it supported economic growth. Clearly, major fiscal reforms, beyond austerity, are required.
BONDS OR EQUITIES?
Consensus is that European bonds looked fair value. Yields are low on absolute levels, although one needs to consider the distortion by ultra-low interest rates. Most of the yields on European high yield names are due to the spread but this spread is not enough to reward investors for the risks they are taking.
Furthermore, we are unconvinced of the yield premium for European high yield debt versus that of the US. There have been strong flows into this space, and supply is robust, but most of this is refinancing, meaning demand could outstrip supply. High yield bonds are correlated with equities, so it is preferable to look to European equities instead.
Despite the negative backdrop, we believe one can make money investing in European equities. Similar to the UK, investing in Europe provides access to global leaders with exposure to emerging markets, thus helping to circumvent local risks.
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Joined as head of strategy, multi asset, in June
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