EEA - The European Equity Fund: The Tailwinds Nudge The Headwinds

2023-04-08 04:16:55 ET

Summary

• Energy-related inflation could stall industrial production momentum in France.
• European banks offer some advantages relative to their US counterparts.
• EEA offers good value.

In America, everything goes and nothing matters, while in Europe nothing goes and everything matters. - Philip Roth

Introduction

Paid subscribers who viewed this week's global section of The Lead-Lag Report would note that I've highlighted how European equities are in a better place than their US counterparts. If you're on the lookout for candidates from this hotspot you may consider the European Equity Fund (EEA).

EEA is a long-standing (since July 1986) close-ended fund that offers investors exposure to 65 companies domiciled across Europe. On a YTD basis, EEA has enjoyed a solid enough run, delivering double-digit returns, twice as much as the US markets and the global markets.

Could this outperformance continue? Well, I wouldn't want to make any definitive statements, but let's focus on some of the pivotal themes that could weigh on EEA's prospects.

France

If EEA is to do well, you'd want its French-based equities to experience sanguine conditions, as those stocks account for close to a quarter of the total holdings, which incidentally also gives them the largest weight in aggregate.

Last month, I put out a tweet on the Lead-Lag Report Twitter account noting how inflation in France continued to hover around the 6% levels, which also represented its highest point in three decades. In light of that, the most recent inflation reading in March ( 5.6% ) was no doubt very welcome, but I wouldn't necessarily get too enthused, as it is still a long way from the ECB's comfort level of 2%.

Crucially, it's also worth noting that the lingering effects of the energy shock continue to impact the smooth flow of industrial production in France, particularly some of the energy-intensive industries such as steel, paper, chemicals, etc, which continue to face double-digit declines.

Earlier this week, we got to know that various members of OPEC+ were planning to curtail production, which could equate to over 1.6m barrels per day coming off from the system. This is bound to stoke up energy-related inflation which could put a limit on industrial production progress in France. All in all, ING expects French industrial activity to decline in the quarter and have a negative contribution toward overall economic growth.

European financials

EEA's portfolio is also dominated by financial stocks. In the 'Leaders-Laggers' section of The Lead-Lag Report, I've also noted how European financials have outperformed their US counterparts.

This is primarily on account of the notion that Europe is just more tightly regulated (and probably better positioned to deal with contagion risks) than the US and the industry is also largely dominated by a few large names, quite unlike the US where you have a lot of poorly capitalized regional banks. FYI, the liquidity coverage ratio ((LCR)) of European banks ranges from 146%-200%, well above the regulatory minimum of 100% while the major US banks typically have lower LCRs of around 119%. In addition to that, European banks are also priced at a price-to-book value of only 0.65x , a 25% discount to the corresponding multiple of US banks.

Currency

Currency dynamics too appear to be moving in favor of EEA. In Jan I noted how the Euro had been demonstrating solid strength on account of the ECB's desire to keep pressing the rate hike pedal. That narrative still holds, even as it looks like the US Fed could be poised to change its stance, thus dampening the allure of US-denominated assets. We can see this being reflected in the EUR/USD pair which has recently completed a rounding bottom pattern and looks set to break out beyond the 1.095 mark.

Having said that, I would also urge investors not to get too carried away by the unidimensional narrative of the dollar's demise and rather take some time out to listen to a recent Lead-Lag Live Twitter Spaces I did with Ryan McMaken. My guest made a strong case for the dollar and its safe-haven qualities that could still boost its allure as we encounter risk-off conditions later on in the year

Valuations and positioning

Despite the outperformance generated by EEA this year, its valuation differential with US stocks still looks very alluring. For context note that the close-ended European fund only trades at 11x forward P/E, a significant discount of over 40% to the corresponding multiple of the S&P500. In light of such drastic variance in the valuation multiples, one would imagine that the S&P500 would offer far better earnings potential, but that is not quite the reality. YCharts expect the S&P500 to generate 5-year earnings of 11.7%, just around 170bps higher than what EEA's holdings are expected to generate.

Meanwhile, a long-term chart showcasing the positioning of European equities and US equities highlights how overstretched things look, with EEA appearing to offer interesting value at these levels.

Besides, as flagged in a tweet on the timeline of The Lead-Lag Report, US markets are currently largely propped up by a small group of mega-cap names, and I have reservations about the staying power of this cohort for too long. Once they give way, you could see accidental conditions pick up steam in April, even though this has traditionally proven to be a good month for US stocks.

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