European equity markets took investors on a rollercoaster ride last year. The STOXX Europe 600 Index, which includes small-, mid- and large-cap equities from 18 European markets, rallied 22 percent in the first four months of 2017, then tumbled 16 percent between April and August, and rallied 14 percent through the end of November.
Investors have started to question Europe’s ability to continue its economic recovery and earnings expansion.
Although equity valuations have discounted a contraction in the EU’s gross domestic product this year, recent strength in the Markit Eurozone Manufacturing Purchasing Managers Index—especially the forward-looking new orders component—doesn’t corroborate this pessimistic outlook.
Europe’s lackluster economic recovery mirrors that in other developed markets, though the region’s equity markets offer more upside because this turnaround remains in its earlier stages and should benefit from growing domestic demand and favorable currency exchange rates.
Consumer confidence remains elevated in the eurozone, while the net investment share of gross domestic product remains at one-third of pre-crisis levels, leaving room for improvement. Low inventories also create the potential for a restocking cycle if domestic demand surprises to the upside.
The severe downdraft in oil prices should also bolster the EU economy, as the 12 percent household savings rate suggests that this wealth effect should translate into increased consumption. Employment also grew at a 1 percent rate—within range of a 10-year high.
The worst also may be behind Europe in terms of the slowdown in emerging economies. Germany, the Continent’s most export-oriented nation, suffered a 50 percent decline in outbound trade with Russia, though this number has stabilized somewhat of late. German exports to China tumbled 11 percent (in euro terms) over the first 11 months of 2015.
International investors have been net buyers of European equities in recent years; at the beginning of last year, monthly inflows stood at a record EUR50 billion. These capital flows have slowed significantly since mid-2015, but we expect this situation to reverse because European equities off better relative returns for long-only investors betting on developed markets.