U.S. optimism, European skepticism: a spring of misplaced market expectations
Since the November 2016 election of President Donald Trump, the U.S. equity market has soared, anticipating that Trumponomics would make “4% the new 2%” for U.S. GDP growth and, by doing so, relegate secular stagnation to the discount bin of discarded economic theories.
However, more than 100 days into President Trump's term in office, the market's optimism appears increasingly difficult to justify from a fundamental cash flow perspective. Regarding the president's pro-growth policy promises, deficit-augmenting tax relief now appears more likely than comprehensive tax reform; a reduction in effective tax rates is probable, but may be smaller and take longer than many expect, and is arguably already priced into equities. Moreover, a major push for increased infrastructure spending doesn't appear in the cards for 2017, and the successful implementation of the deregulation that President Trump has proposed requires that federal agencies have a deep bench of talent in their leadership ranks. Unfortunately, the administration won't have adequate agency leadership in place for at least a couple of quarters, given the sloth-like pace of the congressional confirmation process for presidential appointees.
Springtime in Europe's equity market
In contrast with the high degree of policy uncertainty in the United States, the risks associated with Europe are well known, and, as a result, its equity markets have recently traded at a discount relative to U.S. equities. However, if political disaster is averted in Europe—an outcome that we believe is more likely than not—an interesting investment case for the European equity market could develop.
Regarding France, there is a low risk of a dislocative event in the aftermath of the May 7 runoff presidential election, in which centrist pro-European candidate Emmanuel Macron defeated far-right populist Marine Le Pen. We're more worried about political and economic challenges in Italy than those in France; however, Italy is unlikely to hold a national election until 2018.
Turning to the more constructive fundamentals, the economic data for the eurozone has recently improved, as reflected in its earnings revision ratio—the net number of instances in which analysts have upgraded their earnings forecasts for companies rather than cut them—which climbed in March 2017 to the highest level in more than six years.1
From a performance standpoint, European equities have understandably lagged U.S. equities in recent months, given widespread skepticism regarding the ability of European leaders to implement the policies needed to foster economic stability and growth. The good news is that this underperformance has generated attractive equity valuations in Europe-valuations that could generate interesting investment opportunities if election disasters are averted, if economic improvement continues, and if this improvement feeds through to corporate margins and earnings. These are three big “ifs,” but our confidence level has been growing in recent months.
A high bar in the United States, maybe not so much in Europe
In the United States, we're concerned that economic reality and market fundamentals need to improve considerably to match investors' rather stretched expectations, as reflected in recent equity valuations. In Europe, the situation appears to be reversed: Investors' expectations may have to rise to match economic reality. It's possible that investors have required too high a risk premium to reflect the political uncertainty associated with this year's European elections. Further, there's a strong investment case for leading European companies with global footprints—especially those that generate free cash flow and possess superior management teams with competent capital allocation policies.
1 Bank of America Merrill Lynch, March 2017.