EuropeanOct 2 2013

Global economy still faced bumpy ride on the path to recovery

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As the summer has come to a final close, there is increasing evidence of economic recovery in the eurozone.

The second quarter finally showed positive GDP growth after a record run of six negative quarters. Purchasing manager indices have risen above the neutral 50 level across most of the eurozone, and suggest a broadening and strengthening of the recovery in the second half of 2013.

The improvement has mostly been driven by looser monetary conditions in the wake of Mario Draghi’s ‘whatever it takes’ speech in July 2012 and the introduction of the European Central Bank’s Outright Monetary Transactions programme. This removed the risk of eurozone breakup. A gradual restoration of competitiveness in the periphery has also played its part.

But, lest we get carried away, a return to strong rates of growth is unlikely at least until the structural problems in household and bank balance sheets are worked off.

Nevertheless, a return to growth should boost the performance of European equities in coming quarters, and perhaps we saw the first signs of this in Europe’s relatively robust performance in August. This could challenge stale bearish views on Europe, and force many investors out of longstanding underweight positions in European equities.

The scale of European equity underperformance for the past six years makes clear the potential for a performance catch-up. The case is perhaps strongest versus the US, where the performance and valuation deltas are largest: since early 2007, the MSCI Europe ex UK index has underperformed the MSCI World index by some 25 per cent, and the MSCI USA index by nearly 40 per cent (local currencies).

There has been some disagreement among commentators as to where the long run of weak performance has left European equity valuations. But this is largely due to the fact that European earnings have suffered during the recession and are at depressed levels, hurting valuation metrics based on current earnings.

Therefore on a current trailing price to earnings ratio (p/e) of 16.3x, Europe ex UK does not look particularly cheap compared with the US at 16.7x. But using a cyclically adjusted p/e on the basis of a 10-year moving average of earnings (also known as Cape) paints a very different picture: on this basis Europe ex UK is on a p/e of 14.9x, some 27 per cent below the 30-year average of 23.5x.

For comparison, the US is on a cyclically adjusted p/e (Cape) of 22.5x, roughly 9 per cent below its 30-year average of 24.7x. Avoiding the earnings problem altogether by using price-to-book ratios gives similar results: Europe ex UK equities are trading roughly 25 per cent below their 25-year average, while US equities are at a 15 per cent discount on the same basis.

Even simple p/e valuations should improve as Europe ex UK earnings recover alongside the global economy. Europe ex UK is likely to show the best earnings momentum in 2014, with consensus looking for 13 per cent earnings per share growth in 2014, up from 0.5 per cent this year. In the US, meanwhile, earnings growth of 10 per cent in 2014 will be a more modest acceleration from this year’s expected 6.2 per cent. Japan should have negative momentum going into 2014 after the massive earnings jump this year, while emerging market equity earnings momentum looks likely to be flat.

Another positive for European equities should be the relative trajectories of monetary policy. The ECB’s monetary policy is likely to remain very loose for some time. This is in contrast to the US, where policy is now slowly moving towards a less loose stance. If this feeds through into a weaker euro, it should further boost European earnings.

The list of what could go wrong in Europe remains long, of course, with a political collapse in a peripheral country and further problems in the banking system right at the top. However, with austerity receding, surely so must political risks. And in spite of a number of recent political upsets in the eurozone periphery, bond markets have remained surprisingly calm.

Given markets’ faith in Mario Draghi, it would now take a major political event to really bring out the bond vigilantes. More prosaically, Europe could suffer from weak export demand from emerging economies (China in particular), should growth slow down dramatically. At least the US economy should provide some partial offset.

Patrik Schöwitz is global strategist in the Asset Management Solutions – Global Multi Asset Group at JPMorgan Asset Management

Decisions four: Drivers

Andreas Zoellinger, co-manager of the BlackRock Continental European Income fund, identifies sectors driving decisions today:

Financials are offering opportunities again

In the past few years, market turmoil deemed banks as high-risk investments. There is now a turning point as some European banks start to hold cash on their balance sheets once again while the broader financial sector has seen some insurers also offering prospects, such as Norwegian Gjensidige Forsikring, which has an over capitalised balance sheet.

Many consumer staples are overvalued

Although consumer staples provide dependable income, they are often extremely overbought. They have good global growth and a strong customer base but there are other cheaper, better value stocks available offering equally attractive prospects. For example, industrials provide just as much growth without the cost of paying peak valuations.

The industrials sector brings opportunity for international growth

European stocks with international exposure to developed countries offer attractive opportunities. A number of global industrial stocks have exposure to regions such as the US which are driving recovery. Within industrials, mid-cap stocks are interesting as there is often a low forecasting efficiency for dividends.

Some domestic infrastructure companies still offer value

Many domestic infrastructure companies offer value, even though they do not grow dividends in the same way as inflation protection income growth stocks. This is because they already pay a sufficiently high income through a constantly attractive dividend yield.