Developed European equities have had a pretty good run recently, with the MSCI Europe in euros up 6.3% year to date after dividends (to end July). Strong currency performance has fuelled this still further for overseas investors – in dollar terms the MSCI Europe is up almost 19% including dividends this year, more than 5% ahead of developed market equities in general.
This strong performance is, of course, on the back of very accommodative monetary policy on the part of the European Central Bank; relief that France avoided an anti-EU populist election result; solid, albeit not spectacular, half year earnings releases from companies and depressed starting valuations for both equities and the euro.
Whilst depressed starting valuations were a large part of the story, strong performance for both equities and the euro has led to discounts to other developed economies narrowing. According to figures from MSCI, Europe’s forward price to earnings ratio (PE) is now just under 15, a modest discount to the almost 17 of the MSCI World. It’s price to book value ratio (P/B) is 1.8 against the 2.3 of developed market equities in general.
Whilst valuations aren’t stretched relative to other equities and there are good arguments supporting further recoveries in European earnings, which would likely fuel a further leg up, it’s likely that returns will cool somewhat from here. Those looking for the stellar returns potentially available from truly low valuations will now have to look elsewhere.
But, as it turns out, they may not have to look too far. Value in Emerging European Markets is still compelling.
The constituents of the MSCI Emerging Markets Europe Index: Russia, Poland, Turkey, Greece, Hungary and the Czech Republic, collectively have a forward PE and Price to Book a shade more than half that of developed Europe: 7.7 and 0.9 respectively. Currencies like the zloty and the ruble that register as cheap on most valuation models provide further upside potential.
That said, caveats certainly apply. Firstly, there are the usual emerging market risks: weaker institutions, less transparent equities markets and heightened political risk, such as the increasingly autocratic behaviour of Poland’s ruling Law and Justice party that may result in sanctions by other EU states.
Secondly, the cheapness of Emerging European equities is largely due to Russia which makes up almost half of the index. If you strip out Russia and Turkey and focus on the three largest constituents in the EU, namely Poland, Hungary and the Czech Republic, forward PE’s rise to 12.4 and P/B values to 1.4, still lower than developed Europe but less extreme.
And if you do want to invest in Russia, you do need to realise that its equities have extreme weighting to energy (oil and gas). Almost half of the MSCI Russia’s market cap and thus roughly a third of the MSCI Emerging Market Europe sits in the energy sector.
As is usually the case, high potential for rewards comes with high risk.
So, what is a sensible European investor to do? Stick with developed markets, or shift into cheaper, and racier, emerging markets? The answer, as usual, is that it shouldn’t be seen as an either-or choice. Diversification, in the form of a blend of developed and emerging markets, is the sensible middle path that is likely to lead to the higher risk-adjusted returns over the long-term.
This article first appeared in the September edition of The Trade Press publication.