The incredible rally of the past year and a half has been fuelled solely by the expansion of P/E multiples, causing investors to expect either a violent correction or a sudden improvement in the earnings and economic outlook.
Something does not feel right, and investors are looking to 2014 for answers.
On the technical and sentiment side, equity markets have celebrated the end of the European recession with great exuberance. After the petering out of the Japanese rally in June, Europe has been hit by a wall of money: US-listed Europe equity ETFs took in $15 billion in the past five months about as much as Japan funds took in the first half of the year. It has been 105 days without a 5% correction, the longest such stretch in the past five years.
Positive seasonality and quiet news can delay the pullback until next quarter, which would coincide with poor cyclical tendencies, a potentially difficult earnings season and likely turbulence from US monetary policy.
On the valuation side, the chart shows the relation between earnings growth estimates (x-axis) and the P/E ratio of the MSCI Europe (y-axis). The normal relation should be positive the higher growth expectations, the higher the multiple investors should be willing to pay.
This was overridden between June 2012 and December 2012 as investors repriced European equities after European Central Bank president Mario Draghi promised to do whatever it takes to defend the euro.
|Centre of gravity of the MSCI Europe Index|
Quarterly data since end-May 2012
The second phase of the rally was expectation-driven. The P/E ratio of the MSCI Europe Index rose 16% between December 2012 and July 2013 as earnings growth expectations rose by 1.4%. The last phase of this rally is harder to understand: European multiples have expanded by another 6.4% since July even though earnings growth estimates were taken down.
The bottom line is that the entire European rally came from the expansion of multiples. Buyers of European stocks are now paying 45% more than in June 2012, getting slightly less earnings and have roughly similar growth expectations.
Now that European equities have caught up with historical valuations, the multiple expansion rally needs to give way to the show-me rally: that is, one based on earnings growth. The recent bottoming in European margins suggests that margin expansion could lead to high-single-digit earnings growth next year, despite anaemic top-line growth.
On the macro side, Europes periphery is finally seeing the end of the austerity tunnel. Ireland became the first country to graduate from the adjustment programme and Greece has a primary budget surplus. Less drag from the government sector will be a net positive for growth.
But as the latest GDP numbers show, poor animal spirits and low investment will continue to weigh on the recovery, especially in France and in Italy.
Does the fantastic rally of European equities announce strong recovery of earnings? Or was it a flow-driven, liquidity-inflated illusion? Will Europe fall into a Japan-style deflation or follow the path of the US in 2009?
But, just as Godot does not bother to show up in Becketts play, we expect 2014 to leave investors unsatisfied. Earnings growth will come, but it will leave much to be desired. Growth will likely kick in only in the second half of the year and it will come mostly from margin expansion. Investors will be left wondering how much cost European companies can cut, and they will continue to scan the horizon for signs of top-line growth, most likely in vain.
Thanks to abundant liquidity and a weaker drag from the government sector, European economies should continue to heal slowly. But the recovery will continue to feel extremely weak. Economists will conjure images of triple-dip or quadruple-dip recessions. We would rather say that Europe never really got its head above the water in the first place.
Vincent Deluard is European strategist at Ned Davis Research.