The “United States of Europe” (USE) has been a work in progress since the end of World War II, when the region started the long, painful task of reunification and rebuilding. Now, with fallout from the financial crisis abating and political risk subsiding, Europe is offering some of the most compelling opportunities available to investors today.

Although its path toward the USE was not always clear, Europe made impressive progress by the end of the 20th century – including forming the European Union and launching its common currency, the euro. Yet within the last decade, the European project was almost derailed by the global financial crisis and subsequent euro-zone crisis.

Fortunately, the European Central Bank was able to step in and keep the EU’s economy ticking. And it worked: Today, worries over austerity, political uncertainty and low confidence are beginning to improve, and the USE could be in sight once again. This has a host of positive implications for European equities.

Five reasons to consider European equities

1. Attractive valuations compared with other equities globally
Europe’s GDP and population are larger than the United States’, and many European corporations generate their profits outside Europe. So why should so many European corporations – particularly those in the financial, utility and telecommunications sectors – trade at large discounts to their US competitors? The Case-Shiller P/E of US companies was almost 30 in April; at slightly over 18, Europe’s was significantly lower. With European equities deeply out of fashion, investors have a contrarian opportunity.

Europe is trading at a big discount
The valuation discount between Europe and the US has increased in recent years, as measured by Case-Shiller P/E.

 

2. Low or no bond yields leave little “safe return” regionally
The ECB has been extremely effective in using its monetary and bond-buying policies to lower the cost of credit below zero. This has forced other central banks in Europe – including Denmark and Switzerland – to implement negative rates of their own. As a result, European investors may soon be forced to make a “great rotation” from bonds to equities simply because there are few positive returns available from European bonds. If and when this happens, it will be all the more remarkable because Europe has traditionally had less of an equity-oriented investment culture than the US, the UK and Asia. Fortunately, European equities and alternatives – such as infrastructure debt – provide attractive-yielding alternatives, which could make the switch easier.

3. European economies are finally recovering
As the EU battled with austerity and a broken banking system in recent years, it struggled to find any domestic growth aside from Germany’s well-tuned export machine. As a result, the EU’s nominal GDP growth (which does not factor in inflation) was stuck in the 1-2 per cent range. Today, however, Europe is enjoying a positive spiral of rising consumption, improving investment and falling unemployment, and nominal GDP growth for the EU is now around 3 per cent. Though the EU still has issues – including Italy’s upcoming elections and negotiations over Brexit – it has lower levels of leverage, better savings and a greater ability to increase consumption than the over-leveraged US.

4. Corporate earnings are rebounding after six years of decline
Compared with their US counterparts, corporate management teams in Europe are generally more focused on the long term. Broadly speaking, European balance sheets are also less leveraged, and corporate leaders are generally determined to make investments that improve innovation and productivity. This puts European corporations in a good position to harvest the benefits of their longer-term corporate strategies. As a result, we believe European equities could deliver annual returns in the 8-10 per cent range in the coming years – and we estimate that nearly 50 per cent of this could come from dividend income, which tends to be less volatile.

Among European equities, defence sector stocks are worth watching. In the wake of President Donald Trump’s recent comments about NATO spending, European Commission President Jean-Claude Juncker reiterated the need for countries to stand on their own two feet when it comes to defence. This may translate into increased defence spending across the EU.

5. Europe’s currencies are cheap and attractive
The US dollar has been a safe haven for many of the world’s investors, but its zenith may be in sight. Despite Brexit, the euro and sterling seem quite undervalued. We expect global investors to spend “expensive” US dollars to acquire more attractive, higher-yielding and better-invested assets in Europe – as evidenced by several waves of merger and acquisition activity with European companies.

Watch for continued political challenges

As we move through 2017, it appears that the populist shock wave started by Brexit and the election of US President Donald Trump may be fading. Yet Europe is not out of the woods by any means:

• The UK election result is a reminder that the political landscape continues to throw up surprises. Brexit is far from over, and the direction and likely outcome of those negotiations is difficult to discern.
• Italy still has the capacity to shake the EU and shock the euro. In the run-up to elections next spring, Italy is facing continued political stagnation and an inability to pass much-needed reforms. The risk of a strong anti-Europe result is real.

However, the election of President Emmanuel Macron in France – not to mention his party’s new parliamentary majority – and the likely reaffirmation of Chancellor Angela Merkel in Germany should lead to a constructive partnership between France and Germany. A strong “Merkron” alliance could put Europe back on a path toward achieving the job started in 1950s: a truly United States of Europe.