Tug of War
Does October’s fall in European smaller companies reflect a bout of profit taking, or are investors frustrated by more deep-seated underlying issues as 2014 draws to a close?
For much of 2014 we have been locked in an intense tug of war between those investors who believe we are seeing nothing more than a bit of healthy profit taking in European equity markets and those who think that 2014 is a carbon copy of 2007 for the global economy and markets.
Let’s look at the background first. From the trough of March 2009, the MSCI Europe (ex-UK) Smaller Companies index has risen 183% in sterling terms1. Yet earnings growth hasn’t kept pace with this rise which means that when smaller companies reached their market peak in September 2014 they were trading above their normalised mid-cycle forward price/earnings ratio of 16 times. One of the main reasons for the weakness in markets has been the slowdown in global growth and particularly Europe, where the new normal of low growth has given way to virtually no growth for 2014. This has turned investor attention back to some of the themes of the euro sovereign crisis, most notably the battle to achieve balanced budgets and structural reforms.
It is clear that austerity fatigue has set in across Europe as a result of which the dogma of cuts has given way to less strict government budgets. At the same time, some of the structural reforms that were made possible by the crisis have been delayed, or shelved, with Italy being the prime culprit. So, are we really returning to the eurocentric crisis years of 2011 and 2012?
The first thing to remind ourselves of is that companies are not countries and at the microeconomic level good companies have shown that they are able to thrive during times of low economic growth. This is particularly true of smaller companies that operate in protected niches and, because of their size, can often benefit from secular growth. It is also worth remembering that amidst the disappointment about slow growth Europe has seldom delivered rapid growth in the last twenty years. While many people are feeling increasingly bleak about the eurozone economy and are calling for radical solutions, there are some crumbs of comfort in the form of falling oil prices, a weaker euro, low financing costs and easing austerity measures.
Another potential boost to the economy might come from the continued normalisation of bank lending conditions as European banks put the Asset Quality Review behind them. Now that the banking system has, on the whole, been given a clean bill of health, capital and liquidity buffers are deemed to be sufficient and provisioning is normalising, lending in core franchises to domestic consumers and small and medium enterprises should start to tick up. This may not immediately lead to higher growth as companies have been in balance sheet strengthening mode since the crisis rather than investing in new capacity, but as has been seen in the United States, more share buy-backs and merger and acquisition activity have ensued as a result of returning corporate confidence.
Smaller companies by their very nature offer a blend of growth and cyclicality which has made for a difficult 2014 but offers opportunities for 2015. Secular growth companies have given up some of their premium and real value has re-emerged in cyclical sectors such as auto components and building materials. With Mario Draghi, President of the European Central Bank, increasingly turning words into deeds we are likely to see expansion of the ECB balance sheet to stave off deflation. This should bring some economic and earnings growth into Europe in 2015.
1 Source: Bloomberg