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Europe’s Success Story

Europe’s Success Story. Central bankers do not often make big, bold statements but Mario Draghi made one last week. He said, loud and clear, “our monetary policy has been successful” and listed six measures of Europe’s success story. Here they are, roughly verbatim …

  • Since 2015 real GDP growth has been steady at between 0.3% and 0.6% qoq.
  • The EC economic sentiment index in February was the highest since 2011.
  • The purchasing managers composite index was the highest since April 2011.
  • The unemployment rate in January was the lowest since May 2009
  • In the last three years, the economy has created more than four million jobs
  • The dispersion of growth rates (i.e. how closely countries are growing together) reached an all-time low since 1997.

We have checked his facts and he is right. To pick one, this chart shows the European Commission’s economic sentiment index against eurozone real GDP growth. It is a reasonable coincident indicator and it suggests growth is getting stronger. Indeed, the latest reading is 108.0 but previous peaks were higher – 108.3 in 2011, 113.1 in 2007 and 117.4 in 2000.

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In other words, there is room for the eurozone economy to expand strongly for some while. We imagine that this is one reason why the ECB governing council left a bias to ease in its forward guidance. The ECB expects key official interest rates “to remain at present or lower levels for an extended period” (our underlining). There is little risk in the economy running hot for a while.

Market Puzzle. But the economic success story has not translated well into financial returns. True, bond investors have done well. The return on euro investment grade bonds (on the Bloomberg Barclays aggregate index) was 27% over the past five years. The comparable return in US bonds was 12%. However, Fed and ECB actions explain most of Europe’s higher returns.

In contrast, Europe’s equity market has lagged. Eurozone equity investors earned much better returns in the US than Europe. The FTSEurofirst 300 gave a total return of 61% over the past five years; the S&P 500 returned 92% in US dollars and 142% in euros.

Let’s look at those five-year returns in terms of valuations and earnings. The forward price/earnings ratio rose from 13.4x to 18.3x in the US and from 11.2x to 15.1x in Europe. So both markets gained from rising valuations.

However, forward earnings per share estimates grew in the US (by around 24%) but fell slightly in Europe. A similar pattern was evident in trailing earnings. The cause of European equities’ under-performance was in earnings rather than valuations.

There are grounds for optimism, though. FTSEurofirst 300 earnings are recovering from their mid-2016 low and prolonged low interest rates and economic growth should help that recovery, at least for non-financial firms. With middling equity valuations and rising earnings, we look for Mr Draghi’s European success story to spread beyond real GDP.

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