Why european exposure makes sense

If you read the political headlines, Europe is a mess. Germany does not even have a government, after the inconclusive September election gave rise to four months – and counting – of coalition discussions. Last week, Chancellor Angela Merkel announced that her centre-right CDU party had reached an agreement with its old coalition partners, the left-leaning Social Democrats, but the deal has not yet been ratified by the parties, and there is no certainty that Merkel will remain in her post.

The Spanish province of Catalonia voted last month in a snap regional election that was widely viewed as another referendum on independence: the combined pro-independence parties won a majority of seats, in a setback for Spanish Prime Minister Mariano Rajoy’s government, seemingly entrenching long-term separatist conflict in the country.

Last month, Britain and the EU struck a deal for the UK to conduct its “Brexit,” with a final exit bill of €40 billion–€45 billion ($61 billion–$69 billion). The UK will pay into the EU budgets for 2019 and 2020 as if it had remained in the EU, and will also “contribute its share of the financing” for any EU liabilities incurred before the end of 2020.

Also last month, the European Commission (EC) launched an injunction against Poland for a “serious breach” of European common values and rule of law, for refusing to comply with EU immigration quotas and changes to its judicial system. The EC invoked “Article 7” punishment proceedings against Poland. Article 7 is a mechanism for ensuring that the values of the EU are upheld, but its powers of suspending EU membership rights have never been used.

Italy is facing uncertain parliamentary elections in March, with the anti-establishment 5 Star Movement (M5S) running strongly in the polls, on a platform to recast the country’s relationship with the EU.

Economy not so messy

But turn to the business pages, and it’s a different story. Europe is booming.

The Eurozone’s gross domestic product (GDP) is growing at an annual rate of 2.5%, its strongest growth rate since March 2011. The unemployment rate for September dropped to 8.9% from 9%, representing the lowest joblessness rate since 2009. Eurozone business activity is expanding at the fastest pace in nearly seven years: in manufacturing, the forward-looking purchasing managers’ index (PMI) survey shows activity at its highest level since 1997.

Business confidence is particularly strong in Germany – it recently reached the highest level ever in the reunified country, and levels not seen in the former West Germany since 1969 – while in France, the composite PMI (covering manufacturing, services and construction) hit a 17-year high in December.

The Italian economy is expected to grow by about 1.5% in 2017’s final figure, its best performance since before the Eurozone financial crisis. In Spain, 2017 ended with the lowest jobless figure since 2008, although the independence crisis in Catalonia – which accounts for about one-fifth of Spanish GDP – is a large political problem. The Netherlands recently reported its lowest unemployment rate since June 2009, at 4.4%. The euro surged 14.1% against the greenback in 2017.

This improved economic performance is showing up in company earnings – and as a result, on the stock market. Europe’s markets had a mostly good year in 2017, but were arguably hampered by the constant political concerns. In Germany, the DAX Index gained 12.5% for the year, while in Paris, the CAC 40 index was up 9.3%. The pan-European benchmark, the Euro Stoxx 600 Index, added 7.7%.

These returns were nowhere near as strong as the euphoric returns in the US market, where the Dow Jones Industrial Average jumped 28.1%, the broader S&P 500 was up 21.8%, and the technology-heavy Nasdaq Composite Index surged 29.6%.

But for investors contemplating their international shares allocation, that just might be the point, in justifying a deeper look at Europe.

The argument for a European allocation

The Eurozone economic cycle is widely considered to be lagging that of the US by about three years. The US stock market has run ahead very strongly, but EU stocks appear to offer quite a bit of catch-up potential.

According to financial data compiler Factset, the S&P 500 currently trades on a prospective price/earnings (P/E) ratio – that is, using analysts’ consensus estimates of the next year’s earnings – of 18.3 times earnings. In contrast, the Euro Stoxx 600 index currently trades on a forward P/E of 15.6 times earnings.

Strategists at Man Group say that European shares are at their lowest discount ever versus US shares. Morgan Stanley has just raised its overweight recommendation on European stocks and trimmed its US holdings, saying it expects European stocks to outperform US shares this year. Fellow investment bank Citi predicts earnings growth of 10%–15% in Europe in 2018, which it expects to flow into an 18% rise in the Stoxx 600 index.

With many investors expecting P/E compression in the US in 2018, Europe – especially if the perceived political risks do not eventuate to the extent that pessimists believe – could see a significant re-rating of its share market.

This has a couple of major implications for Australian investors’ international allocations. The first is that global exchange-traded funds (ETFs) may, by virtue of the strong US performance, now carry heavy exposure to an over-valued US market. The second is that more Europe-focused ETFs may as a result offer better value at this point.

There are five major ETFs that cover the European market:

ANZ ETFS Euro STOXX 50 ETF (ESTX:ASX)

Up 19.8% over the last 12 months in A$ terms, slightly behind its benchmark, on 19.98%.

Management Fee: 0.35% pa. 

Source: nabtrade

ESTX focuses on the Eurozone’s large-cap stocks – it tracks Europe’s main blue-chip index, the Euro Stoxx 50 Index, which contains 50 of the largest stocks from 12 countries within the Eurozone. (It does not include UK-based companies). Many of these are not really European stocks, in the same way that the Dow Jones Industrial Average heavyweights are not really US stocks – they are global mega-caps that happen, because of their history, to be headquartered in Europe.

This blue-chip focus distinguishes ESTX from the other Europe-focused ETFs on the ASX, which are more broadly based. ESTX gives investors access to global household names like L’Oréal, Louis Vuitton Moët Hennessy (LVMH), Siemens, Daimler, BNP Paribas, Unilever, Airbus, Philips and Nokia.

Managed for 0.35% a year, ESTX is unhedged.

According to Bloomberg, the Euro Stoxx 50’s relative strength index (RSI), a momentum indicator that tracks the magnitude and speed of price fluctuations, is the only one among major markets not in “overbought” territory – compared to the S&P 500 Index, the MSCI World Index, the Nikkei and the MSCI Emerging Markets Index.

 

Vanguard FTSE Europe Shares ETF (VEQ:ASX)

Total return (after management costs) of 16.95% in last 12 months, slightly behind benchmark, on 17.41%. Since inception (9 December 2015), VEQ has returned total return of 6.92% a year, compared to 7.49% a year for benchmark.

Management fee: 0.35% a year

Source: nabtrade

The Vanguard FTSE Europe Shares seeks to track the return of the FTSE Developed Europe All Cap Index (with net dividends reinvested) in Australian dollars, before fees, expenses and tax. This unhedged ETF provides low-cost, broad exposure to major European stock markets.

 

iShares Europe ETF (IEU:ASX)

Total return 15.68% in 2017, versus 16.01% for the index

Total return over five years to December 2017: 13.4% a year, versus 13.8% a year for index

Total return since inception (July 2000): 1.96% a year, versus 2.34% a year for index (IEU lost 50% in first 2.5 years, and again in 2007-08)

Management fee: 0.6% a year

Source: nabtrade

The iShares Europe ETF gives an investor exposure to a large range of European companies. The fund tracks the S&P Europe 350 index, and is mainly invested in shares in the United Kingdom, France, Switzerland and Germany. Its heaviest weightings are in financials, consumer staples and healthcare. IEU is unhedged.

 

BetaShares WisdomTree Europe ETF Currency Hedged (HEUR:ASX)

Total return 14.10% in 2017, versus 13.99% for the index

Total return since inception (10 May 2016): 16.79% a year, versus 17.3% a year for index

Management fee: 0.58% a year

Source: nabtrade

HEUR is a very different ETF to the iShares, Vanguard and ASX ETFs offerings: it is a “smart beta” ETF, designed to capture the return of a specialised index that is built around particular investment “factors” – in this case, the index (built by US ETF provider WisdomTree) is designed to capture globally competitive dividend-paying European companies.

The index constituents trade in Euros and also generate at least 50% of their revenue outside Europe. The rationale behind investing in these stocks is that they are well placed to benefit from growth in international trade, and the potential ongoing reliance by European economies on exports and currency weakness to sustain economic growth.

By weighting stocks according to dividends, moreover, the HEUR ETF also biases the exposure toward companies with the potential to produce sustainable profits, and which are focused on shareholder value.

The other major difference is that HEUR is currency hedged: this reduces currency risk from the fluctuations of the Euro against the A$. And because European overnight inter-bank interest rates are still negative, the currency hedging also takes advantage of the relative difference between European and Australian interest rates. In effect, the investor is being paid to borrow euros and use them to buy Australian dollars, which earns a higher interest rate return.

 

UBS IQ MSCI Europe Ethical ETF (UBE:ASX)

Total return in year to 30 November 2017: 26.79%, versus 26.99% for index

Total return since inception (18 February 2015): 5.87% a year, versus 6% a year for benchmark

Management cost: 0.4% a year

Source: nabtrade

UBE is also a unique player in this mini-sector, because of its ethical investment bias: it excludes companies with significant business activities involving tobacco and those engaged in the production of cluster bombs, landmines, chemical and biological weapons and depleted uranium weapons.

Even with the ethical tweak, UBE provides a diversified core exposure across European share markets, the index that UBE tracks, the MSCI Europe ex-Tobacco ex-Controversial Weapons Index, captures the large and mid-cap representation across 15 developed markets countries in Europe. With about 430 constituents, the index covers about 85% of the free float-adjusted market capitalisation across the European developed markets equity universe. UBE is unhedged.