U.S. equities surged over the last six years as the economy regained its footing after the financial crisis, and companies underwent substantial cost cuts to improve profitability. Today, many international companies and regional economies are early in the process of making similar positive, transformative changes. Guy Scott, Co-Portfolio Manager of the Janus International Equity Fund, explains why the international sequel could be favorable for equity investors.
Déjà vu across the pond?
The U.S. economy and corporate America have undergone transcendent changes since the Great Financial Crisis, as government stimulus jump-started the economy and individual companies made cost cuts to run leaner and meaner than ever. The transformation has been reflected in domestic equities, which have enjoyed a six-year bull market and continue to hit new highs.
While the U.S. run could continue, we think it is an opportune time for investors to look across the Atlantic, where big changes are still in the early stages at the corporate and macroeconomic levels. Investors seeking to participate in the potential upside realized by these actions would be well served to invest ahead of those changes, not behind.
Europe holds potential for economic improvement
Efforts by the European Central Bank to stimulate the region’s economy have been later, and smaller in magnitude, than in the U.S., but given the threat of deflation, heavier stimulus efforts are likely on the way. And unlike previous efforts, which were hampered by macroeconomic threats such as a slowdown in Chinese demand and tension between Ukraine and Russia, we expect new stimulus measures to have a bigger impact on reviving the economy and sparking loan growth.
While Ukrainian-Russian tensions remain, several recent developments could improve consumer and business confidence, translating renewed stimulus into actual loan demand and economic growth.
• Property prices in Europe have stabilized.
• Europe’s banks came out of recent Asset Quality Reviews – Europe’s version of a stress test for its banks – unscathed, which provides more confidence in the health of the financial system.
• Capacity utilization in Europe hovers near 80%, the tipping point at which businesses typically make heavy investments and capital expenditures.
Margin expansion should benefit many European stocks
European companies have been slowly and quietly getting lean and mean like their American counterparts. Coming out of the Financial Crisis in 2008, profit margins in Europe severely lagged those in the U.S. because European companies were slower to enact cost-cutting measures to their businesses. Instead of making cost cuts or tough layoff decisions, most European companies waited for the government to bail out an industry or jump-start the economy. After another economic slowdown unfolded in Europe in 2012, and again in 2014, many European businesses are now taking matters into their own hands.
At many large European corporations, we’re seeing management teams spin off or restructure unprofitable businesses. Companies are also making big cost cuts and gaining major union concessions to become more profitable. For evidence of the latter, look no further than the French auto industry. Historically, France has been known for having very strong unions. But when capacity utilization for the French auto industry dipped to 50% in 2012, unions knew they had to acquiesce to concessions or face a greater number of jobs moving to Eastern Europe and other low-cost production bases. French unions at large automakers such as Ford, Peugeot and Renault agreed to close plants and reduce capacity to make their operations more efficient and ensure manufacturing plants in France survive for the long term.
As cost cuts work their way through European businesses, European companies could see considerable earnings growth through margin expansion, without the need of a strong economic tailwind. We believe stock prices will follow.
Invest ahead, not behind
While we believe improvements to European companies are on the way, they are not yet reflected in valuations. Investors who were in front of such changes in the U.S. have likely enjoyed watching those changes shake out over the last six years. Now may be the time to turn attention abroad.
While we see opportunity with many European stocks, the road ahead calls for a selective approach. Stimulus in Europe should benefit the economy broadly, but will be more impactful to select industries and companies. More importantly, the magnitude of cost cuts at each company differs significantly. While many companies have followed through with meaningful restructuring, others have paid only lip service to the need for cost cuts. Those specific companies that made real cost cuts are poised for greater margin expansion and profit growth, and represent the best opportunities in international markets.
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