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European markets reflect upbeat mood

Early signs of improving economies on the Continent have added fuel to the recent stock rally

By: SIMON AVERY

Date: March 26, 2015

Sometimes investors just pick the wrong things to worry about.

Take widespread fears of Greece’s “imminent” exit from the euro zone, for example. Canadians who have bulked up on domestic assets while shunning European markets have lost out on double digit returns, only then to be hit by the fallout of collapsing energy prices.

Despite whatever negative impression Canadians have about Europe’s future, Europeans themselves are increasingly upbeat and their stock markets are reflecting that confidence.

Measured in local currencies, European stocks have far outpaced U.S. and Canadian equities recently, with the benchmark MSCI Europe index gaining about 17 per cent so far this year and 24 per cent over the past 12 months. The comparable figures for Canadian and U.S. benchmarks are 2.4 per cent and 7.7 per cent, and 1.2 per cent and 13.9 per cent, respectively.

“Canadians’ incredible home bias [for stocks] has always just struck me as stark raving mad,” said Brad Radin, chief investment officer of Radin Capital Partners in Toronto.

Boasting only about 2 per cent of the world’s public equity value, and an even smaller fraction of its population, Canada offers only a tiny window of investing opportunities, heavily concentrated on energy, mining and banks. “For most Canadians, investing 10 per cent of their holdings internationally is not going to complicate their portfolios. But it is going to decrease the risk tied to all things Canadian,” Mr. Radin says.

In the United States, the high dollar is going to hurt a lot of corporate earnings. In Europe, the low euro will likely have the reverse effect, he says. About 21 per cent of assets in the Radin Global Opportunities Fund were in Europe at the end of February, second only to China, which accounted for 35 per cent of the fund’s holdings.

Europe’s recent strength may represent the early days of a bigger cycle, some money managers say.

“Europe is on a long-term bull market over five to seven years,” said Peter Hadden, co-manager of Fidelity Investment Canada’s Europe fund. “But there are going to be pauses, there are going to be stops and starts.”

During the past year, many investors have set aside fears about Greece, deflation and the fallout from Russian aggression to take advantage of low valuations for European companies relative to North American counterparts. That price advantage has now nearly disappeared, but early signs of improving economies in the euro zone have added fuel to the rally.

Economic sentiment, for example, rose for the second month in a row in February, driven by consumer optimism, building on solid gains over the past two years.

With Europe’s manufacturing sector expanding and the banking sector starting to lend more, employment inched upward throughout last year. GDP rose modestly in the final months of the year, led by Ireland’s torrid 4.8-per-cent rate of expansion, according to the European Union’s statistics agency.

Shortly before the European Central Bank launched its 1.1-trillion euro asset-buying program this month, ECB president Mario Draghi announced that the bank was boosting its economic forecast for the currency bloc to 1.5 per cent GDP growth for this year, up from 1 per cent.

“Although data improvements remain in early stages, earnings outlooks and ECB stimulus certainly seem to support investors’ sentiments,” said Lindsey Bell, senior analyst, global markets intelligence, S&P Capital IQ.

After big declines in earnings growth last year, European companies are expected to see their profits rise by an average 6.9 per cent this year. That compares with almost flat-line conditions in the United States and a significant 11.1-per-cent drop in earnings growth for Canadian companies, according to consensus estimates from S&P Capital IQ.

Estimates for Canada likely reflect falling oil prices. Nevertheless, Canadian companies have both negative estimated earnings growth and the highest valuations when their price-to-earnings multiples are measured next to expectations of their long-term growth rate – something S&P analysts term “an alarming combination.”

In addition to expected profit growth, European companies as a whole are sitting on hoards of cash. At almost 5 per cent, their average free cash-flow yield is higher than that of companies in the S&P 500 and S&P/TSX, according to S&P Capital IQ. (Free cash-flow yield is defined here as operating cash flow minus capital expenditures measured as a percentage of total enterprise value.)

If activist shareholders step up pressure on European companies to unload some of that cash, and boards of directors have enough confidence about the economy’s future, investors could see dividend increases, more share buybacks and an increase in acquisitions, Mr. Hadden said.

In addition to considering the fundamentals of the European market, Canadian investors need to assess the likely direction of the euro in relation to the Canadian dollar. What’s more, they need to make their call on currency at a time of higher-than-normal volatility in the currency markets – a situation caused by tumbling energy prices and anticipation of an interest-rate hike by the U.S. Federal Reserve.

“A big pall on this market is currency, and you’ve got to be very cognizant of your currency exposure,” Mr. Hadden said.

For U.S. investors, the strong dollar has wiped out a lot of the gains in European stocks. But for Canadians and their weaker currency, the trade has been more balanced, and many fund managers advise against a currency hedging strategy at this time.

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