Europe's recovery on track

The European Central Bank (ECB) has reached a crucial milestone in its 15 year history, as it joined the rest of the 'G-4' major central banks with its first quantitative easing (QE) programme. The widely expected €1.1trn of stimulus should be supportive for European growth and assets.

The size of the stimulus package exceeded predictions, with expectations before the announcement being around the €500-750bn mark. This has been well flagged but hasn't caused much market volatility so far. We believe the market will continue to view QE positively and we remain constructive on European equities. Though the euro may weaken further in the long-term, we think most of the move is over for now.

Our market positions

We are overweight in European equities and peripheral European debt, in the portfolios where we can hold bonds directly. Where we can hedge the excess euro exposure, we are modestly underweight on the single currency. Our main reasons for these positions are as follows.

The economy

We see the European economy improving this year, aided by euro weakness, stabilisation in the peripheral economies, a recovery in consumer spending and lower oil prices. Two of Europe's strongest economies at present are Spain and Ireland, following reforms that investors have recognised by pushing yields on their respective 5-year debt to 0.7 per cent and 0.5 per cent.

Meanwhile, Germany continues to display robust growth, with unemployment down to a 20-year low of 6.5 per cent. Spain's leading indicator has risen since 2013, suggesting that return on equity (ROE) for Spanish companies could rebound from current low levels.

One of the less widely considered aspects of QE is its so-called 'wealth effect'; the indirect positive effect on the spending of consumers who see their wealth increase as asset prices get a lift from QE. By this measure, the ECB looks likely to get less 'bang' for its euro.

According to research by Guggenheim, the wealth effect from QE in Europe is expected to about 40 per cent less than it has been in the US, where households hold a much higher proportion of their wealth in stocks, bonds and other financial assets. It is likely to be positive for equities but have less of a potential inflationary impact.

Policy

ECB President Mario Draghi overcame resistance from the Bundesbank to produce the widely expected QE, and has left the door open for further QE if needed.

We consider Draghi to be a very experienced communicator who sees an opportunity to take the lead now, and be seen as a catalyst for an economic recovery we think is already on the go. This will boost his credibility as a central banker and his influence on future policy.

While QE of the size and structure delivered was largely discounted, we still consider it supportive for European equities. It should also be positive for peripheral Eurozone bonds, though the scope for further capital gains following the recent rally is limited.

A more expansive monetary policy usually means a weaker currency, and we expect further dollar gains against the euro in the longer-term, but much of the QE announcement was discounted already in the euro's recent underperformance.

Valuation

Our analysis of cyclically-adjusted price/earnings ratios (PEs) for the US and European equity markets since 1985, shows that European equities look far cheaper than their US peers - and exceptionally cheap versus both government and corporate bonds.

Outside of Greece, the highest-yielding five year European bond is (junk-rated) Portugal at 1.6 per cent, while Swiss, Danish, German, Finish, Austrian, Dutch, French and Belgian bonds have yields that are already negative or close to zero.

By contrast, the dividend yield on European equities is close to 4 per cent and dividends are growing. What is particularly unusual is that the dividend yields for about 80 per cent of large European companies are higher than their bond yields. This means they can issue bonds to buy back equity and save cash, while raising earnings per share. We expect this relative value to drive further equity gains in 2015.

We are in an era of extraordinarily low yields on low-risk assets, so value in fixed income is scarce. But we note that the fundamentals in the European periphery continue to improve, with fiscal and current account (trade) deficits reversing in Spain, Greece and Portugal. This combined with ECB QE action should lead to peripheral debt outperforming further.

James Butterfill is global equity strategist at Coutts

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