European equities have been in a strong recovery this year, as evidenced by the MSCI Europe Index, which has gained 14.8% year-to-date through May 31, 2017. With European stocks advancing as they have, investors are asking: Is it sustainable?

We are not market timers and firmly believe in a consistent, long-term allocation to international equities, but at the same time, we are seeing encouraging signs that the European rally could be here to stay.

We believe four important factors are driving European equity returns:

  1. Liquidity: Quantitative easing and stimulus from central banks.
  2. Earnings Momentum: The positive change in earnings growth.
  3. Valuation: Stock price relative to underlying financial metrics.
  4. Technical: Money flows into these assets.

Liquidity

It has been a long road for Europe. Fiscal and monetary leaders have had to manage a complicated recovery with various moving parts, including social and financial crises. As a result of European countries resisting monetary stimulus, the European Central Bank did not begin implementing true liquidity measures until 2015. To put this in perspective, the U.S. Federal Reserve began stimulus in 2008, with a total of four major stimulus programmes through 2012. Exhibit 1

Exhibit 1: Central Bank Action -- S&P 500 & MSCI Europe Indices -- OppenheimerFunds

While this puts Europe’s recovery several years behind the United States’, markets have a tendency to reward patience.

The idea behind providing liquidity to financial markets is that the process tends to lift asset prices, increase the velocity of money, and help bring economies back to a sustainable balance. And now, after many years of malaise, economic data in Europe is encouraging.

Earnings Momentum

The global growth engine is reaccelerating. This bodes well for export-heavy markets such as Europe, where corporate earnings growth is recovering. Corporate earnings growth is one of the fundamental backbones of equity performance. The recent surge in earnings growth has surprised investors and acted as a catalyst to recent stock performance.

After five years of negative earnings growth, the long-awaited resurgence in European corporate earnings finally appears to be upon us. Analysts are forecasting European corporate earnings will grow more than 25% in calendar year 2017. Exhibit 2

Exhibit 2: Earnings Growth in Europe Set to Rebound in 2017 -- OppenheimerFunds

Valuation

When earnings momentum meets attractive valuations, investors should typically expect a rewarding outcome.

On the basis of the Cyclically Adjusted Price-to-Earnings ratio (CAPE ratio), which normalises earnings over a full business cycle, European stocks are trading at attractive valuations. As of March 31, 2017, European stocks were 18% undervalued relative to their historical average CAPE ratio, while U.S. stocks were 31% overvalued, compared with their historical average. Exhibit 3

Exhibit 3: Equity Valuations Are Attractive in Europe -- OppenheimerFunds

Technical

Fund flows are a powerful force that can influence equity returns. Investors in the United States have shied away from European equities in recent years and, given the European Union’s general economic weakness, European investors also have been slow to move into equity investments. This has left money on the sidelines that has just begun to be redeployed towards Europe.

Over the past decade, 21% of industry fund flows went towards the Foreign Blend (the majority of which is Europe) and Europe-only equity categories. Following a period in 2016 during which investor allocations to these categories were historically low – at less than 13% – 2017 has offered a very different scenario: Funds are flowing back towards European equities at a more-than 30% rate. This is a trend we believe could persist. Exhibit 4

Exhibit 4: Assets Are Flowing Back Into European Equities in 2017 -- OppenheimerFunds

Leadership Shift from U.S. to International

With these four market forces – liquidity, earnings momentum, valuation, and technical – all favouring European equities at the same time, markets may be in the midst of a shift in geographic leadership from the United States to international.

Historically, these periods of geographic outperformance last for extended time frames. Since 1980, there have been five such leadership changes, with each lasting 67 months on average and generating an average excess cumulative return of 93% for the geographical region in favor. The recent period of U.S. outperformance, from December 2007 through November 2016, lasted 108 months.1 The pendulum may have swung again.

Is the rally in international equities sustainable? The extended period of underperformance for European assets has created a wide valuation gap that could take a long time to correct. Strengthening fundamentals should help turn the tide and close that gap.

While we strive to invest in companies well-positioned for all market environments, this renewed economic strength is certainly welcome.

 
  1. ^ Assumes the current trend of MSCI EAFE outperformance continues and the S&P 500 Index cycle officially ended in November 2016.

The MSCI Europe Index captures large and mid-cap representation across 15 Developed Markets (DM) countries in Europe. With 446 constituents, the index covers approximately 85% of the free float-adjusted market capitalization across the European Developed Markets equity universe