Why Investors Should Own European, UK Stocks Despite Gloomy Headlines

Falling stock prices and currencies are a response to seemingly nonstop bad news from Europe and the U.K. Theresa May’s resignation as U.K. prime minister is the latest chapter of the Brexit saga, and the once unthinkable prospect of a “no-deal” Brexit could become a reality in October. Frustration with centrist politicians was apparent in European Parliamentary elections, though many voters outside the U.K. supported pro-European parties. Italy woes were back in the headlines with the European Commission threatening fines as a punishment for Italy’s failure to rein in debt.

With Italy on the brink of recession and Germany’s slowdown reflected in rising unemployment and the lowest manufacturing PMI since 2012, investors have a lot of reasons to be bearish about economic growth. The counterargument from bullish investors is that Europe and the U.K. have relatively cheap valuations relative to the U.S. In addition, Chinese stimulus may boost growth for export-sensitive European and U.K. companies. There are important lessons to be drawn from both sides of the debate about the investment outlook for Europe and the U.K. Abandoning the region may be an unwise investment strategy, but investing indiscriminately may be equally unwise.

Potential of a ‘No-Deal’ Brexit

The specter of an economically disruptive “no-deal” Brexit is considered more likely with Boris Johnson the early leader in the campaign to become the next prime minister. Johnson and other candidates for prime minister may find being in power more challenging than being “backbenchers” criticizing May’s attempts to negotiate an orderly departure from the European Union. According to one former U.K. government official, in renegotiating 100,000 pages of European Union laws, “everything is negotiable, from financial services to fish and nothing is agreed until everything is agreed.” The risk of a no-deal Brexit may be overstated, as the House of Commons is likely to block such an exit. Market volatility associated with speculation about the potential for a no-deal Brexit or the prospects of socialist Jeremy Corbyn becoming prime Mminister may create buying opportunities for high-quality U.K. assets.

European Valuations and Structural Challenges

European valuations are cheap relative to the U.S. Unfortunately, headline valuations mask fundamental differences between Europe and the U.S. European indexes are much more heavily concentrated in financial services than major U.S. indexes, while U.S. indexes have a greater concentration in faster-growing technology stocks. On a sector-neutral basis, the valuation disparity between the U.S. and Europe is less dramatic. The valuation disparity between Europe and the U.S. may also be attributable to a risk premium associated with the structural challenges facing the euro area.

In the words of a speaker at the CFA Institute Annual Conference, “Europe is a “1 ½ legged stool.” Monetary policy is forced to do much of the heavy lifting, compensating for insufficient labor mobility, the lack of meaningful fiscal stabilizers and a financial system lacking a common deposit insurance program or a robust mechanism to resolve solvency issues.

For insight into the euro area’s structural challenges, all roads lead to Italy. Italy struggled to generate 1% GDP growth in the years following the global financial crisis and today is teetering on the brink of recession. The Italian economy is struggling for reasons that include competition from Chinese exports, lagging productivity growth and high youth unemployment. The technology revolution seemingly left Italy behind, in part because of the dominance of family-run small and midsize companies.

According to TS Lombard’s Shweta Singh, “A key risk not just to Italy but to the euro area as a whole, comes from the intricate links between Italian banks and sovereign debt. Italian lenders’ public debt holdings as a proportion of GDP has been increasing and remains one of the highest in the euro area.”