Despite concerns the strong currency could dampen the macoeconomic momentum, JP Morgan believes these concerns are overdone
Euro's rapid appreciation another signal of Europe's recovery
Europe’s economic recovery remains on track with the upswing continuing to broaden across countries and sectors. European equity markets have returned over 20 per cent this year in US dollar terms but only half of that in euro terms, with the index languishing just below May’s peak in local currency.
The rapid appreciation of the euro has weighed on sentiment, and the equity index, raising concerns that a strong domestic currency could dampen the macroeconomic momentum. We believe these concerns are overdone. The strength of the euro predominantly reflects a more robust euro area recovery than currency markets expected at the start of the year.
Indeed, consensus forecasts for euro-zone GDP have risen significantly since January, from 1.4 per cent to 2.1 per cent currently. A loss of confidence in the strength of the Fed’s hiking cycle appears to have also manifested in further upwards pressure on the euro versus US dollar. When analysing the effect of a stronger euro on corporate profitability, it is most relevant to consider the effective (or trade-weighted) euro; where price appreciation has been far less material and equates to only a few percentage points headwind to profitability.
We continue to experience a cyclical recovery in Europe and believe the evidence is growing that structural change is also afoot. As such, share price weakness driven by currency strength, and recent geopolitical friction, are an opportunity for investors to buy into the region’s recovery.
Within the euro zone, we now advocate exposure to the French CAC 40 index, having previously favoured German equites (DAX and MDAX indices). The German equity market is Europe’s most global (with around 23 per cent of revenues generated on home soil) and the weakness of the euro in recent years boosted companies export performance. The DAX is also highly concentrated (the largest five firms make up over 40 per cent of the index’s market cap.) Assisted by effective labour market reforms, Germany’s earnings have advanced significantly over the past five years, despite economic turbulence on the continent.
However, now that Europe’s economic recovery is accelerating and broadening out, we believe investors will be better rewarded for shifting exposure to France where we see the potential for greater earnings upside over the next 12 months, and optionality over reforms at the French and European level.
The earnings of the French CAC 40 index stand 20 per cent below where they were in 2007. This contrasts with Germany’s DAX index where significant earnings growth leaves the index’s earnings-per-share 45 per cent above pre-crisis peak. We see catch-up potential, with domestic activity accelerating in France. The French equity index has an attractive sector and geographic mix which fits with our view that both the European and the world economy will perform well into next year.
In terms of geographical exposure, the CAC 40 index is more domestic and should therefore be more insulated if the euro were to remain strong. Looking at sector weightings, the CAC 40 is biased towards banks (beneficiaries of a strong domestic economy) and industrials. Trading in-line with the broader European index on a price to earnings multiple, the French large cap index can enjoy modest multiple expansion if the earnings acceleration comes through, as we anticipate.
While we believe in global reflation, the path to monetary normalisation will be slow and steady in Europe leaving investors still searching for income. A further attraction of the investing in the French index lies in its dividend, with a 3.2 per cent yield growing in excess of 7 per cent per annum compounded annually, according to current analyst forecasts.
Finally, the French equity risk premium could benefit from structural reform. The election of the president Emmanuel Macron in May of this year raised hopes that France will increase its focus on fixing a chronic lack of competitiveness and high level of unemployment by implementing reforms.
These hopes have faded recently, yet we remain optimistic that this government will steer the country in the right direction. We are not expecting game-changing reforms but we believe that any progress will be incrementally positive for sentiment and could lead to renewed investor interest and inflows. In addition, now that the German chancellor Angela Merkel has been re-elected, we also expect to see the potential for a stronger Franco-German partnership leading to reforms at the European level.
Grace Peters is the executive director and European equities strategist at JP Morgan Private Bank