European stocks scale the political wall of worry

By Jamie McGeever

LONDON (Reuters) - Politics have rarely been more fraught on either side of the Atlantic in the post-war era, and yet European stocks are marching steadily higher - casting doubt on the old adage that markets don't like uncertainty.

Voters go to the polls this year in France, The Netherlands and Germany on a rising tide of populism that is out to challenge the established order built since World War Two.

None of the far-right parties seems to have a strong chance of securing power. Nevertheless, since the surprise outcome of last year's U.S. presidential election, financial markets remain particularly apprehensive about the possibility - however slim - of the anti-euro Marine Le Pen winning the French presidency.

But the improving European economy and a recovery in corporate profits, at a time when debt yields are still historically low, gives investors little choice but to remain heavily invested in riskier, higher-yielding assets such as equities. That leaves bond markets to reflect the anxiety.

Figures on Tuesday showed that despite the political uncertainty, euro zone private sector and manufacturing growth accelerated to near a six-year high in February and job creation reached its fastest since August 2007.

"We just don't know how these political risks will play out. It's incredibly difficult to take actionable, informed investment decisions in this environment, so some portfolio managers aren't making any changes," said Neil Dwane, global strategist at Allianz Global Investors.

"In the meantime, investors have to hunt for a return," said Dwane, who was previously the group's Europe Equities chief investment officer.

That's a widely held view in an investment community still struggling to explain 2016. Even those who sailed against the tide to predict Britons would vote to leave the EU and Donald Trump would make it to the White House would probably have been wrong-footed by the subsequent moves across stock markets.

Apart from initial short-lived volatility, they have climbed steadily. Investor bets on Trump's fiscal largesse and tax cuts reflating the U.S. economy have put a rocket under Wall Street, especially bank stocks, and Europe has benefited too.

Euro zone stocks have lagged Wall Street this year. The Eurostoxx 50 is up 2 percent year to date, less than half the 5 percent increase that has lifted all three major U.S. indices - the S&P 500, the Dow Jones Industrial Average and the Nasdaq Composite - to record highs.

But over a slightly longer period, the Eurostoxx 50 has outperformed the S&P 500 since Trump's victory on Nov. 8, rising 11 percent compared with 10 percent. That has been achieved without the huge inflows from retail investment funds which have propelled U.S. stocks.

According to fund flows tracker EPFR, U.S. equity funds have drawn a net inflow of $84 billion (£67.5 billion) since the election, of which $10.9 billion has come this year. European funds have posted a $511 million net outflow since election day, but a $606 million inflow this year.

"People are still under-allocated to Europe. Retail money has gone into U.S. markets, but not Europe. Not yet," said Stephen Macklow-Smith, head of European equity strategy at JP Morgan Asset Management.

VALUATION GAME

In The Netherlands the anti-Muslim, anti-EU party of Geert Wilders holds a narrow lead in opinion polls but even if he wins parliamentary elections he will struggle to form a coalition government with mainstream parties.

In Germany, the far-right Alternative for Germany is polling just in double figures but conservative Chancellor Angela Merkel's chief threat is from the mainstream, pro-Europe Social Democrats.

That leaves investors to worry particularly about Le Pen's anti-euro stance in France. Polls this week showed the National Front candidate is narrowing the gap on her more centrist opponents if, as expected, she makes it through to a second-round run off scheduled for May.

The bond market reacted quickly and decisively to the polls. The premium investors demand for holding 10-year French debt over ultra-safe German bonds shot up this week to the widest since 2012, at around 85 basis points.

Still, at just over 1 percent, France's nominal 10-year borrowing costs are less than a third of what they were at the height of the euro zone debt crisis in late 2011.

Stocks are taking a much more sanguine view. At 14.9 currently, the Eurostoxx 50 measure of implied volatility is near its lowest ever levels. It has posted a monthly close below 15 only once in over 10 years.

On valuation terms, there's also a case to be made for the euro zone relative to Wall Street. The price-to-earnings (P/E) ratio for the S&P 500 index is now at 17.8, well above the euro STOXX 50 index's 13.85 times its 12-month forward earnings, according to Thomson Reuters Datastream. That gap has rarely been greater. http://bit.ly/2kUiEYv

Macklow-Smith at JP Morgan Asset Management notes that European banks' return on equity (RoE) last year was about 4.3 percent, compared with a 10-year average of 7.4 percent. Before the crisis, it was between 10-15 percent.

Because the average RoE over the last decade has been so skewed by the global financial crisis and then the euro zone debt crisis, there is reason to believe it will be higher over the next decade.

Stephane Monier, Head of Investments at Lombard Odier Private Bank, said he started to reduce his underweight position in European equities last month, even as the political outlook got murkier.

"Given a constructive macroeconomic environment and positive earnings dynamics, we are keeping the overall level of equity risk in portfolios unchanged at slightly overweight," Monier said.

(Reporting by Jamie McGeever; Graphic and additional reporting by Atul Prakash; editing by David Stamp)