The big opportunity in European stocks

By Chad Fichardt, an independent finance and technology communications specialist.

European equitiesOver the last few years South African investors have seen the importance of diversifying their portfolios. Money invested on the JSE has hardly grown since the middle of 2014, but many international markets have performed very well.

This has been particularly true in the first half of 2017. While the JSE All Share Index was up just 3.37% to the end of June, the MSCI World Index climbed 10.66%.

There are however now concerns that some of the world’s large markets are looking over-valued. The S&P 500 in New York, for instance, is currently trading on a price-to-earnings ratio of nearly 26 times, which is well above its long-term average of just under 16.

This puts many local investors in a bit of a conundrum. They want to make sure that they have international exposure, but they are cautious about current market valuations.

A region that is therefore receiving growing interest is Europe. Markets in the Eurozone have under-performed for some time, but there are growing indications that this is changing.

For the first six months of 2017 the Eurostoxx50 index was up 17.24% in dollar terms, making it one of the world’s best-performing markets. Investors are being attracted back into the region as its economic and political environment show encouraging signs of improvement.

“Europe has been in a bit of a slump for the last few years on the back of the Greek crisis and uncertainty around the future of the European Union, however we are now starting to see growth coming back into the region,” says Brian McMillan from Investec. “The result of the recent French elections has also added some stability to a Eurozone that had been facing a lot of political uncertainty.”

Improving fundamentals

What is particularly positive for investors is that Europe is at an earlier stage of the economic cycle than the US. This means that there is stronger earnings growth potential for local businesses, many of which are showing improved profit numbers.

“The fundamental backdrop continues to support a positive stance on the European market,” Ronan Carr, a European equity strategist at Bank of America Merrill Lynch, pointed out in a recent note. “The earnings backdrop is very strong.”

As investors have generally been underweight European equities, there is also the likelihood of strong inflows into the region as these fundamentals continue to improve. This will add further support to these markets.

“A reduction in risk premia, combined with an end to the seven-year stagnation in European earnings should drive inflows into European equities,” Barclays strategists noted recently. “We envisage the coming months to resemble the previous periods of heavy inflows into European equities relative to other regions.”

For investors looking at a broad global picture, diversifying into Europe also makes sense in terms of managing the risk in their portfolios. Most global equity funds, particularly index-trackers, will have a very high exposure to the US market, and in the current environment that may need to be managed.

“The US makes up nearly 50% of world markets and it has done extremely well over the last nine years since the financial crisis,” Investec’s McMillan notes. “But a lot of people are looking at it now and saying that at the moment it probably doesn’t offer the best value. That supports the argument for wider diversification, and Europe is an obvious place to look.”

Gaining exposure

An important question for South African investors is how best to gain exposure to European equities, and particularly the Eurostoxx50 Index. This is the most recognised benchmark in the region as it is made up of Europe’s biggest companies across 11 countries, including Bayer, SAP, Siemens and LVMH.

One option is through the db X-trackers Eurostoxx50 exchange-traded fund (ETF) listed on the JSE. This provides simple, low-cost access to a rand-denominated investment that can be bought and sold as simply as a local share.

Some investors may however prefer to actually take their money offshore and invest through an international broker. This means that their investment will be made in Euros, and that they are protected against any South African-specific risks.

Low-cost ETF options include the HSBC Eurostoxx 50 ETF, which has a total expense ratio of just 0.05%, and the iShares Core Eurostoxx 50 ETF, which costs 0.10%.

For investors looking for additional risk protection and that are comfortable with a Rand denominated investment, Investec is currently accepting investments into its Wealth Accelerator Equity Structured Product, which provides 100% capital protection over a four-year period. If the Eurostoxx 50 Index grows at all over this time, even by just 1 point, investors will receive a return of 63% in rand terms, which is an annualised 13%.

“The 100% protection to a fall in the index provides protection for investors who are worried about markets being expensive,” explains McMillan. “If the US market does have a correction that will feed into other world markets, and so this product mitigates that risk. And at the same time the product offers a big kicker, even if there is only marginal growth.”

In a global environment of low growth, the ability to earn a 63% return (in rands) for a small move in the index is highly attractive.

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