Europe, Japan — A Flash in the Pan?

A frequently asked question of global equity investors in recent years has been, “When will European and Japanese stocks start to outperform the U. S.?”

US and non-U. S. equity markets have historically alternated in terms of relative performance, but the most recent period of US outperformance has been longer than normal. That’s not entirely surprising given the Eurozone sovereign debt and banking crisis, Japan’s earthquake and nuclear disaster, Brexit and, more fundamentally, better US earnings growth. This past year, helped by the weaker US dollar, has been the first since 2012 in which developed-market equities outside the US have outperformed.

Is this the beginning of another long cycle, or just a flash in the pan?

From Skepticism to Optimism

Sir John Templeton, one of the great contrarian investors, once said, “Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria.” US equities have certainly benefited from optimism since the US elections a year ago — in particular as investors anticipated tax reform. Valuations are high and the current bull market is one of the longest in history.

The recovery in Europe and Japan this year has been treated with a much higher degree of scepticism, however. Concerns still abound with regard to the sustainability of the European economic recovery and its political outlook, as well as the slow impact of Abenomics in Japan and the threat from North Korea.

A Synchronized Upswing in Europe

Although pockets of Europe have been growing successfully for several years — Germany, Switzerland and the Nordic countries come to mind — the economic recovery has now broadened, with almost all countries showing an acceleration over the past 18 months. Quarterly growth has been positive for the last 17 quarters, and the ECB recently raised its Eurozone growth estimate for 2017 to 2.2 per cent. With growth now similar to US levels, domestic demand, capex and corporate profit growth are all improving. Combined with the relatively low level of interest rates, this explains a sharp increase in M&A activity.

Europe still has relatively low capacity utilisation, and Eurozone unemployment is still at 8.8 per cent, versus 4.1 per cent in the US. That should mean less cost and wage pressure, which could help Europe’s corporate profits outgrow those in the US. It could also delay increases in interest rates by either the ECB or Bank of Japan.

In addition, the political situation now looks far clearer than it did at this time last year, when investors feared that a wave of support for nationalist and anti-EU parties could set in motion the beginning of the end of the Eurozone. In most cases, however, the opposite has happened, with pro-EU candidates winning in Spain, the Netherlands, France and Germany. Angela Merkel of the CDU still has work to do to build a coalition in Germany, but the main opposition party is, if anything, even more pro-EU, so the risks are low in our view.

It is even more encouraging to see real reform in Europe. Spain took the lead a couple of years ago, but the new French President Emmanuel Macron is delivering on campaign promises for labour market reform and tax cuts in Europe’s second-biggest economy. These reforms could help address structural problems that have hampered investment, jobs, wages, consumption and growth in France for decades.

Within sectors, European valuations are similar to those of the US but offer the prospect of sustainably higher earnings growth. Moreover, valuation multiples in Europe are less likely to suffer the effects of an increase in interest rates, as the ECB is likely to lag the Fed in its trajectory.

Of course, there is uncertainty around Brexit, which could be a source of volatility both in the UK and then the Eurozone. Recent news suggests movement toward a less disruptive, “soft” Brexit, but even the worst-case scenario of trade based on WTO rules would not be the end of the world for Europe: There will be winners and losers among different sectors, but companies will adapt.

Opportunities in Japan despite structural headwinds

The economic backdrop is less appealing in Japan, which suffers from structural challenges that include high debt, poor demographics, weak consumption and low inflation. That said, Japanese companies stand to benefit more than most from the current global economic growth upswing given their strong focus on exports of machinery and equipment. With costs less sensitive to revenues than in other markets, Japanese corporate profits (and profit margins) have risen, and its return-on-equity gap with the rest of the world is narrowing.

Japan also remains a global leader in industries with strong secular growth characteristics, such as factory automation and cosmetics: Stock pickers can avail themselves of these opportunities while avoiding areas facing long-term headwinds.

Despite highly publicised cases of bad corporate behaviour, such as Toshiba (accounting scandal) and Kobe Steel (quality control scandal), we are finally seeing improvements in corporate governance. A greater focus on capital discipline could see valuations rise commensurate with the improvement in returns.

Momentum

With these ongoing improvements, it is not unreasonable to expect investor scepticism toward non-U. S. equity markets to mature into optimism at some point during the next 12-18 months, especially as contrarians begin to worry about euphoria in other markets. Should the current economic and political momentum continue in Europe, and global trade hold up, we certainly believe that European and Japanese stocks can sustain 2017’s outperformance into 2018.

Benjamin Segal, Portfolio Manager and Head of Global Equity Team, Neuberger Berman.