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MARKET
INSIGHTS

Market Bulletin
February 2014

The opportunity in European equities

David M. Lebovitz
Global Market Strategist

Vincent Juvyns
Global Market Strategist

To learn more about the
Market Insights programme
please visit us at
http://am.jpmorgan.co.uk

Over the past few years, European economies have suffered from an
extended period of slow growth and recession, but at the same time,
investors in European equities have enjoyed a cumulative total return of
over 130%1. This highlights that, although European equities have not
been popular over the past few years, they have in fact been profitable.
European equities managed to gather positive momentum in bleak
economic conditions, and now, as some of the clouds that have been
hanging over Europe finally begin to dissipate, we believe that there is
additional upside and opportunity for European equity investors. We have
observed that quality European companies, even those in the periphery,
do not need rapid growth in the broad economy in order to deliver
returns to their shareholders, suggesting that even a mild acceleration in
growth over the coming quarters could provide a tailwind for the asset
class. However, it is important to remember that a rising tide may not lift
all boats equally, and that the next few years may see more meaningful
dispersion in performance. This dispersion will create an opportunity to
add alpha as investors cast a more discerning eye towards securityspecific fundamentals now that the panic-inducing risk-on, risk-off swings
are seemingly behind us.
European growth strikes back
Following several years of struggle against its sovereign debt crisis, Europe is finally
finding its way out of recession, and a gradual cyclical recovery appears to have begun.
As shown in Exhibit 1, the real European economy grew by 0.1% year on year (y/y) in the
third quarter of 2013, marking the end of the deepest recession the region has
experienced since the common currency was established. In addition, most recent
economic data suggests that the economic expansion gathered pace in the fourth
quarter of 2013, with the eurozone composite PMI finishing the year at a level of 52.1
and eurozone economic sentiment hitting a 29-month high in December. Interestingly,
the country-level breakdown of both indices shows that the recovery has been broad
based, and it is particularly comforting to see that economic momentum in the
peripheral countries has seemingly turned positive.
1 Based on MSCI Europe total return index. Data as at 16 Jan 2014.

MARKET

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DISCUSSION:inTitle
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The opportunity
European
equities

INSIGHTS

EXHIBIT 1 – REAL GDP EU27, CHANGE YEAR ON YEAR

EXHIBIT 2 – UNEMPLOYMENT RATE FOR SELECTED C0UNTRIES

6
%
4

14
%
12
10

2

Average

8
6

0

EU

4

-2

US

2
-4
-6
-8

Avg since 1999
Real GDP

1.4%

0

3Q13
0.1%

Germany
’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11

’12

’13

Sources: Eurostat, FactSet, J.P. Morgan Asset Management.
Data as at 31 December 2013.
’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11

’12

Sources: Eurostat, FactSet, J.P. Morgan Asset Management.
Data as at 31 December 2013.

Other data points support this view. The credit rating outlook for
Spain and Portugal has been upgraded by Standard & Poor’s, and
Ireland has managed to regain its “economic sovereignty” by
exiting the troika bailout package. Meanwhile, since Mario Draghi
announced the European Central Bank’s (ECB’s) outright monetary
transactions (OMT) programme, the spread between most 10-year
peripheral bond yields and the 10-year German Bund yield have
dropped to or below 200 basis points. This has helped peripheral
countries stabilise their economies, and given them time to
implement tighter fiscal policies and structural reforms aimed at
restoring their competitiveness. Furthermore, unit labor costs
have now decreased substantially in the periphery, which, in the
absence of floating exchange rates, is contributing to a necessary
rebalancing in the eurozone.
While the recovery seems real and appears to be broad based, in
most parts of Europe it remains, so far, a fragile and a jobless
recovery. Indeed, unemployment rates across Europe remain
uncomfortably high (Exhibits 2 & 3) and, as time passes, the risk
that cyclical unemployment becomes structural is increasing. As a
result, bringing high unemployment rates down must remain a
priority for European policymakers.

2 | The opportunity in European equities

EXHIBIT 3 – UNEMPLOYMENT RATE FOR SELECTED EUROPEAN COUNTRIES

30
%
25

Spain

20

Italy

15

Greece

Portugal
Ireland

10
5
0
’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11

’12

’13

Sources: Eurostat, FactSet, J.P. Morgan Asset Management.
Data as at 31 December 2013.

According to Okun’s Law2, real GDP growth must exceed 1.6% y/y
for unemployment to fall, which suggests that policymakers will
need to use a wide range of resources to stimulate growth. On top
of its dramatic social consequences, high unemployment also has
deflationary effects, and although it may be too early to speak
about deflation, the very low rate of inflation (Exhibit 4) could
pose risks to the peripheral countries by making it harder for
them to increase competitiveness and lower their debt ratios.
2 Okun’s law describes the inverse relationship between an economy’s unemployment rate
and growth.

EXHIBIT 4 – INFLATION EU27, CHANGE YEAR ON YEAR

The ECB will (have to) battle on all fronts

5

Despite an improving economic backdrop and rising asset prices,
the ECB may have to provide further stimulus in 2014 to support
growth and bring inflation closer to 2%. While the ECB is already
in the business of providing forward guidance on interest rates, it
has several options left that can be employed to stimulate growth
and inflation, including quantitative easing, a negative deposit
rate, additional rate cuts or a new long-term refinancing
operation (LTRO).

Avg since 1999 Dec 13
Headline CPI
Core CPI

4

2.5%
1.9%

1.0%
1.1%

3

2

„„Quantitative easing seems the least likely option given the

1

practical and legal difficulties of buying sovereign debt, but
given a shock of sufficient size, it cannot be ruled out.

0
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11

'12 '13

„„A negative deposit rate might incentivise healthier banks to

increase lending to weaker banks, thereby decreasing the
fragmentation in the interbank lending market and in the
eurozone more broadly. However, this measure would bring
money markets into relatively uncharted territory, and may be
counterproductive in terms of monetary policy transmission,
as negative deposit rates could impact the availability of
liquidity to the interbank market.

Sources: Eurostat, FactSet, J.P. Morgan Asset Management.
Data as at 16 January 2013.

However, in 2014 and beyond, we have good reasons to believe that
Europe will continue on its recovery path. As shown in Exhibit 5,
fiscal drag for the 2013-16 period will be lower than it has been over
the past three years, a reduction which should be supportive of
stronger economic growth. In addition, the new German coalition
led by Angela Merkel is expected to implement slightly more
pro-growth policies, characterised by more infrastructure spending
and the implementation of a minimum wage, which could support
growth not only in Germany, but across the continent.

„„An additional refi rate cut is probably the easiest option, but

its impact will be limited. While the latest 25 basis point rate
cut, in November 2013, has shown the ECB’s commitment
to supporting the economy, it has failed to make the cost of
overnight funding cheaper, as Eonia nearly doubled in the
weeks following this intervention.

Investors are beginning to see that there is light at the end of the
tunnel for Europe, and by the end of 2014, most of the region will
hopefully have left recession behind. However, a few good data
points do not necessarily constitute a trend, and investors should
not become complacent simply because growth has moved into
positive territory. That said, despite the structural challenges that
still face the region, stronger growth and falling deficits suggest
that the eurozone economy may finally be on the mend.
EXHIBIT 5 – GOVERNMENT DEFICIT REDUCTION % OF GDP

7
%
6

6.7

6.2

2010-2013
5.2

5
4

2010-2016F

5.0
4.4
3.4

3.4

3

3.8

3.7
3.1
2.4

2.0

1.9

2
1

3.1

3.0

2.7
2.2

2.4

2.2

1.5

1.1

0.5

1.1

0
-1
-2
-3

-1.9
Greece

Ireland*

USA

Portugal

UK

Germany

France

Eurozone

Spain

Netherlands

Italy

Belgium

Sources: IMF World Economic Outlook October 2013, FactSet, J.P. Morgan Asset Management. Data as at 31 December 2013.
J.P. Morgan Asset Management | 3

MARKET

PORTFOLIO
DISCUSSION:inTitle
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The opportunity
European
equities

84.8

80

80.2

79.6

79.5
62.0

60

20.5

2.0

UK

Portugal

Ireland

2.5

Japan

0

15.6

14.4

13.5

USA

40
20

3.5

3.0

Sources: European Mortgage Federation, Bank of England, Mortgage Bankers
Association, J.P. Morgan Asset Management. Data as at 31 December 2013.

1.5
1.0
0.5
0
’05

%

Belgium

EXHIBIT 6 – ECB BALANCE SHEET: ASSETS € TRILLIONS

100

Germany

probably be the most realistic and efficient solution. As shown
in Exhibit 6, the ECB’s balance sheet has declined by 26%
from its peak due to repayments of earlier LTROs by eurozone
financial institutions, and this has coincided with a stronger
euro. Given that inflation is already too low and growth is
quite weak, the European economy could benefit from an
increase in liquidity and from any subsequent weakening in
the euro that another LTRO might trigger.

EXHIBIT 7 – ARM ISSUANCE % NEW RESIDENTIAL MORTGAGE LENDING
1Q07-1Q13 AVERAGE

Netherlands

„„Growing the ECB’s balance sheet with a new LTRO would

Spain

INSIGHTS

’06

’07

’08

’09

’10

’11

’12

’13

Sources: ECB, FactSet, J.P. Morgan Asset Management.
Data as at 31 December 2013.

Although it is unclear what measures the ECB will take in 2014,
many believe that policymakers will need to do something
convincing to maintain abundant liquidity and keep the short end
of the yield curve well anchored. At the same time, the ECB will
have to monitor the long end of the yield curve as, like in 2013,
10-year bond yields in Europe might be influenced by rising
interest rates in the US. While the economic situation in the US
might justify somewhat higher yields, this is not yet the case in
Europe. Furthermore, due to the prevalence of adjustable-rate
mortgages (ARMs) in Europe (Exhibit 7), especially in peripheral
countries, the housing market might suffer if interest rates
prematurely rise. This provides further support for another LTRO,
as this indirect form of quantitative easing appears to be one of
the more effective tools for maintaining control over long-term
interest rates that we have seen thus far.

4 | The opportunity in European equities

In sum, we believe that the ECB will take additional action in 2014,
but it is not yet clear what form this action will take. In whatever
form, though, further stimulus should support the improvement
in sentiment that is already underway, and subsequently benefit
both the European economy and equity markets.

From crisis zone to investment opportunity
Assuming that the eurozone recovery remains on track, European
equities look positioned to follow up on their strong performance
last year with decent, albeit more modest gains in 2014.
While some of the gains over the past few years have been a
function of easy monetary policy, an improving economy, coupled
with a supportive central bank, should help drive further equity
market appreciation going forward. Looking at a breakdown of
returns over the past few quarters, multiple expansion has been
the primary driver of returns, causing valuations to rise. As shown
in Exhibits 8 and 9, European equities are no longer as cheap as
they were a year ago, but this is, to an extent, a reflection of the
removal of the existential question that still hung over the future
of the common currency at the time. However, it is important to
keep in mind that these higher valuations not only reflect more
certainty about the future, but also the broad improvement that
has occurred across the eurozone; while these developments have
led European equities to no longer look as cheap as they once did,
current valuations do not yet indicate that they are overly
expensive.

EXHIBIT 8

MSCI Europe Index: Valuation Measures



Historical Averages

Valuation Measure Description

Latest

1-year average

3-year average

5-year average

10-year average

15-year average

P/E

12.9x

11.4x

10.9x

11.0x

11.9x

14.3x

Price to Earnings

P/B

Price to Book

1.84

1.52

1.53

1.53

1.71

1.74

P/CF

Price to Cash Flow

8.5

7.2

7.0

6.8

7.1

7.2

P/S

Price to Sales

1.1

0.9

0.9

0.9

0.9

0.9

PEG

Price/Earnings to Growth

1.1

1.1

1.1

1.1

1.2

1.3

Div. Yield

Dividend Yield

3.6%

4.0%

4.1%

4.2%

4.1%

4.0%

Sources: MSCI, IBES, FactSet, J.P. Morgan Asset Management. All valuation metrics are forward looking with the exception of price to book (P/B).
Data as at 31 December 2013.
EXHIBIT 9 – MSCI EUROPE FORWARD P/E RATIO

EXHIBIT 10 – MSCI EUROPE INDEX: GEOGRAPHICAL SOURCE OF REVENUES

24
X
21

RoW
12%

18
15

Average: 13.8x

12

31 Dec
2013:
12.9x

9
6

Asia
10%

Americas
24%

Europe
54%

’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14

Sources: MSCI, FactSet, IBES, J.P. Morgan Asset Management.
Data as at 31 December 2013.

There are a plethora of high quality companies in Europe, many
of which are multinational corporations with global revenue
streams. Many of these multinationals are large global exporters
that have been able to maintain profit margins and achieve
top-line growth throughout the crisis, rewarding shareholders
who were able to deal with intermittent bouts of volatility.
Looking forward, investors in European equities may benefit from
indirect exposure to emerging markets in 2014, as growth looks
set to accelerate following the rough patch in the second half of
2013. In addition, as shown in Exhibit 10, European companies
derive over 50% of their revenues from Europe, and as a result
should not only benefit from a healthier global economy, but from
further improvement in the European economy as well. This
benefit should span the market capitalisation spectrum, as
smaller companies, particularly parts manufacturers, see
increased demand for their products as economic growth
accelerates. Nominal GDP growth in Europe is highly correlated
with sales per share of European equities (0.84 since March
2002), which suggests that stronger nominal GDP growth should
translate into healthy top-line growth. Given that profit margins in
Europe are currently around average, stronger revenue growth
has the potential to translate into solid earnings for European
corporations even if profit margins hold at their current levels.

Sources: MSCI, Thomson Reuters Datastream, Worldscope, J.P. Morgan Asset
Management. Data as at 31 December 2013.

European companies have used the past few years as an
opportunity to restructure and become more competitive, which
could present an additional opportunity for investors. While
valuations may not be quite as attractive as they once were, as
mentioned earlier, further improvement in the economic
backdrop should translate into stronger corporate profits. When
you purchase a share of stock in a company, you are purchasing a
right to the future earnings of that company; this is why in theory,
stock prices should follow earnings. Stronger earnings growth
seems feasible in 2014, particularly if economic growth
accelerates. While estimates tend to decline over the course of
the year, analysts currently expect earnings per share for the
STOXX 600 to rise by just over 13% to a level of €24 in 2014
(Exhibit 11), an improvement that, if it materialises, should help
push equity markets higher.

J.P. Morgan Asset Management | 5

MARKET

PORTFOLIO
DISCUSSION:inTitle
Copy Here
The opportunity
European
equities

INSIGHTS

Conclusion

EXHIBIT 11 – STOXX EUROPE 600 ANNUAL EARNINGS ESTIMATES
WEEKLY EARNINGS PER SHARE CONSENSUS ESTIMATE

35

’09



’08
’12

30
’07

’13

’14

’10

25

’06

20

’01

15

’98

’02

’99 ’00

’11

’03 ’05
’04

’97
10

’96

5
’95

’97

’99

’01

’03

’05

’07

’09

’11

’13

Sources: Source: STOXX, FactSet, J.P. Morgan Asset Management.
Data as at 31 December 2013.

Opportunities are not without risks
While the macroeconomic environment in the eurozone has
improved notably over the past few quarters, headwinds will not
be absent in 2014. First, given that the recovery is still in its early
stages, it remains vulnerable to shocks, policy error and other
setbacks. While a significant downshift in growth is not our base
case, output remains well below its previous peak, and the threat
of deflation has not yet dissipated. In addition, investors need to
be aware that the above-average equity returns and belowaverage volatility of the past two years are uncharacteristic of
markets in general, and as such, prepare for what might be a
bumpier ride ahead.
Second, the ECB has begun its comprehensive assessment of the
European banking system, a crucial step on the road to
establishing a much-needed banking union. The most important
part of this process will be the asset quality review (AQR), due to
be completed by the end of 2014, which is meant to assess
whether banks have adequate capital to cover their credit
exposures, and evaluate the valuation of the collateral being held
against these loans. Previous stress tests of European banks did
not reveal serious problems, but lacked credibility, partly for that
reason. While the ECB is widely expected to be more rigorous in
its assessment, if it reveals large holes in bank balance sheets
that cannot be easily filled, the review could revive the very fears
that it was meant to dispel.

6 | The opportunity in European equities

Although our base case is for a continued eurozone recovery and
further gains in risk assets over the course of 2014, the road
ahead will undoubtedly be full of unforeseen twists and turns. It is
important to keep in mind that the European recovery is still in its
initial stages, and many questions remain, particularly
surrounding the viability of the crisis countries. However, even in
the periphery, good European companies have not needed rapid
economic growth to deliver healthy returns to shareholders, a
dynamic which may continue to hold true if growth fails to
materialise going forward.
If it does materialise, stronger nominal GDP growth should
translate into stronger corporate revenues and profits, a
development which should be supportive of European equity
market gains. However, we expect that markets will develop an
ever more discerning eye for the fundamentals, and believe that
investors should participate in equity markets with the
understanding that a rising tide does not lift all ships. In the next
few quarters, we expect a greater dispersion between “winners”
and “losers”, and our conviction remains that investors will
benefit from taking an active approach to European equity
investing in the years ahead.

MARKET
INSIGHTS

PORTFOLIO
DISCUSSION:inTitle
Copy Here
The opportunity
European
equities

The Market Insights programme provides comprehensive data and commentary on global markets without reference to products. Designed as a tool to help clients
understand the markets and support investment decision-making, the programme explores the implications of current economic data and changing market conditions.
This document has been produced for information purposes only and as such the views contained herein are not to be taken as an advice or recommendation to buy or sell any
investment or interest thereto. Reliance upon information in this material is at the sole discretion of the reader. Any research in this document has been obtained and may have
been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily
reflect the views of J.P. Morgan Asset Management. Any forecasts, figures, opinions, statements of financial market trends or investment techniques and strategies expressed are
unless otherwise stated, J.P. Morgan Asset Management’s own at the date of this document. They are considered to be reliable at the time of writing, may not necessarily be allinclusive and are not guaranteed as to accuracy. They may be subject to change without reference or notification to you. Both past performance and yield may not be a reliable
guide to future performance and you should be aware that the value of securities and any income arising from them may fluctuate in accordance with market conditions. There is
no guarantee that any forecast made will come to pass.
J.P. Morgan Asset Management is the brand name for the asset management business of JPMorgan Chase & Co and its affiliates worldwide. You should note that if you contact
J.P. Morgan Asset Management by telephone those lines may be recorded and monitored for legal, security and training purposes. You should also take note that information and
data from communications with you will be collected, stored and processed by J.P. Morgan Asset Management in accordance with the EMEA Privacy Policy which can be accessed
through the following website http://www.jpmorgan.com/pages/privacy.
Issued in Continental Europe by JPMorgan Asset Management (Europe) Société à responsabilité limitée, European Bank & Business Centre, 6 route de Trèves, L-2633 Senningerberg,
Grand Duchy of Luxembourg, R.C.S. Luxembourg B27900, corporate capital EUR 10.000.000.
Issued in the UK by JPMorgan Asset Management (UK) Limited which is authorised and regulated by the Financial Services Authority. Registered in England No. 01161446. Registered
address: 25 Bank St, Canary Wharf, London E14 5JP, United Kingdom.
LV–JPM6410 | 01/14


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