Equities strengthened over H1, the Euronext 100 gaining four per cent over the period. However, this masks a sharp turnaround in June. Having achieved a high of 760 (up 12 per cent year to date) towards the end of May, the index has since declined to 727 at the time of writing (up seven per cent year to date.)
It is hard to be optimistic that we have turned a corner in the eurozone and that underperformance relative to the US will start to reverse
The S&P has fared considerably better, posting a 15 per cent gain year to date. Although US equities also declined in June, they still outperformed their European counterparts by a hefty four per cent during the month.
The substantial underperformance of European equities demands a search for an explanation. It is easy to assume that a fundamental weakness will be found out in times of stress.
Two important observations can help shed light.
Firstly, there is the simple fact that some economies are performing substantially better than others. The US economy is putting clear water between itself and the eurozone – but so is Germany relative to its southern neighbours within the eurozone.
The US outperformance is clearly much stronger than the headlines suggest, if one were to strip Germany out of the comparative. Germany’s economic trajectory shares more with the US than it does with the likes of Italy and Spain. This schism at the heart of the eurozone, with surplus countries continuing to power ahead at the expense of deficit countries which continue to stagnate, fuels fears that the eurozone is unsustainable. To the extent that they are justified, so is the market weakness.
The second observation is that, from the same US vs eurozone perspective, sectoral valuations are highly correlated in some cases, but are diverging in others.
For example, the likes of Nestlé are on a similar rating to US counterparts such as General Mills – a historic price/earnings ratio of around 18x for both.
Conversely, telecoms and utilities are on substantially lower ratings in Europe. For example, Verizon is trading on 19x, while Portugal Telecom is trading on 14x. It is true that one cannot draw too narrow a comparison between individual companies, but these examples are fairly typical across the sectors.
In the case of high dividend paying utilities, outperformance has occurred despite the specific headwind facing US stocks in the form of a higher risk of interest rate rises – making the income stream relatively less attractive.
However, what is even less attractive is the prospect of the dividend not transpiring at all. Verizon has a yield of 4.7 per cent, while Portugal Telecom has a yield of 8.7 per cent – that is a clear reflection of the relative risks attached to the income streams. The risk is as real for Portugal Telecom as the austerity measures which Portugal is being subjected to by the EU.
A point of difference between the two sets is that the former is exposed to global demand, while the latter is more exposed to eurozone domestic demand – and the political and regulatory risk attached to what might be seen as “excess profitability” in the context of a cash-strapped economy.
Note for example the headline for a recent analyst report on Portugal Telecom: “Economy and regulation drag Portugal”.
The earnings of sector heavyweight Vodafone are constantly impacted by weakness in its eurozone businesses.
One analyst has remarked that Vodafone must ensure that its more attractive businesses, such as Vodacom (South Africa) and Vodafone India, are fairly recognised by investors and not given the same low rating as the eurozone businesses.
Looking to the near future it is hard to be optimistic that we have turned a corner in the eurozone and that underperformance relative to the US will start to reverse. Until fairly recently, bulls have pointed to declining yields in the eurozone as evidence that the worst is behind us.
That reasoning failed to grasp the underlying reality that much of the eurozone is still struggling – and will continue to do so unless policy changes.
The lower yields primarily reflected a more expansive strategy at the ECB, not an improved performance.
More lately, rising yields suggest that we are approaching the next pressure point.
This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business.
Martin Webster is head of equity research at Curmi and Partners Ltd.