The Euro­pean eq­uity blues

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

The rel­a­tive per­for­mance of Euro­pean stocks has been dis­ap­point­ing lately. Even though the Euro­pean Cen­tral Bank de­liv­ered its promised eas­ing, trig­ger­ing both a fur­ther de­cline in pe­riph­eral bond yields and a weak­en­ing of the euro, eu­ro­zone stock mar­kets have un­der­per­formed the US by 6% since early June in lo­cal cur­rency terms, and by 7.25% in US dol­lars. How­ever, there are two ways of look­ing at any sell-off. Ei­ther it is the begin­ning of a new down­ward trend, or it presents a good buy­ing op­por­tu­nity. Although in­vestor con­fi­dence has clearly taken a beat­ing in re­cent weeks, in this in­stance the bal­ance be­tween fi­nan­cial and eco­nomic con­di­tions does not point to a pro­longed weak­ness in Euro­pean eq­ui­ties. thus, the com­ing weeks should of­fer in­vestors at­trac­tive buy­ing op­por­tu­ni­ties ahead of a stronger fourth quar­ter.

A nasty com­bi­na­tion of heavy US fines on Euro­pean banks, western sanc­tions on Rus­sia, and an iso­lated but painful fi­nan­cial bank­ruptcy in Por­tu­gal ac­counts for much of Europe’s re­cent poor per­for­mance. Even so, Euro­pean stock mar­kets have proved dis­ap­point­ingly frag­ile. In early July, we ar­gued that a strong US econ­omy, a proac­tive ECB and a de­clin­ing euro would be enough to keep eu­ro­zone stock in­vestors en­gaged even as the ac­cel­er­a­tion in growth paused. But, mea culpa, we were too op­ti­mistic. In­stead, the lack of mo­men­tum in cor­po­rate prof­its has made in­vestors very ner­vous. In­deed, the dif­fer­ence in price per­for­mance be­tween US and Euro­pean stocks mir­rors the di­ver­gence of growth in for­ward earn­ings per share since the end of last year: up 5% for the MSCI US, ver­sus –0.5% for the MSCI EMU (in lo­cal cur­rency terms). Tak­ing a longer view, even the re­cent cor­rec­tion is still con­sis­tent with the idea that Euro­pean mar­kets are sta­bil­is­ing af­ter five years of dra­matic un­der­per­for­mance from 2007 to 2012. What is new is that the cor­rec­tion has taken place against a back­drop of de­clin­ing mone­tary and sys­temic risks in Europe. Since Jan­uary, longterm Span­ish bonds have out­per­formed even US stocks, and the cru­cial OAT-bund spread has de­clined to just 35bps, from 60bps at the end of last year. Hold­ing a bas­ket of Euro­pean bonds has thus proved to be a good hedge for eq­uity port­fo­lios.

Skep­tics will ar­gue that the de­cline in Euro­pean bond yields is just more ev­i­dence of loom­ing de­fla­tion, and that re­joic­ing to­day about lower in­ter­est rates in Europe is as short-sighted as it would have been in Ja­pan in the 1990s. We dis­agree. Even though Ger­man bond yields have reg­is­tered new lows re­cently, by far the best per­for­mance was re­turned by bonds that carry a ‘credit risk’, not by safe haven plays. This en­cour­ag­ing devel­op­ment is par­al­leled by im­prov­ing prospects for do­mes­tic growth in key ar­eas. Spain, which un­til re­cently was the largest de­fla­tion­ary mael­strom in the eu­ro­zone, grew by an an­nu­alised 2% in real terms in the first half of the year. In the ser­vice sec­tor—which is more do­mes­ti­cally-driven than man­u­fac­tur­ing—the eu­ro­zone pur­chas­ing man­agers in­dex set a new high for this cy­cle in July, while re­tail sales rose 2.4% year-on-year in June, the high­est read­ing since 2007.

Granted, there are ma­jor ar­eas of con­cern, no­tably in France and in Italy, where GDP de­clined -0.2% in the sec­ond quar­ter, con­tra­dict­ing the pos­i­tive mes­sage sent by busi­ness and con­sumer sur­veys. Even so, in­vestors’ fears over cor­po­rate prof­its are ex­ag­ger­ated. The ag­gre­gate level of cor­po­rate earn­ings has tem­po­rar­ily been dragged down by a se­vere profit re­ces­sion in the tele­com and en­ergy sec­tors, and ex­change rate moves whose im­pact is now in the past. We are es­pe­cially com­forted by the favourable mo­men­tum in the Euro­pean ‘Mit­tel­stand’-for­ward EPS are up 16% YoY in the small cap uni­verse. The game of chicken with Rus­sia may put pres­sure on eu­ro­zone ex­porters-Adi­das, for ex­am­ple, has down­graded its growth fore­casts- but ex­ports should ac­cel­er­ate again by the end of the year as US growth picks up. And with the euro now lower, ex­porters’ prof­its should ben­e­fit more than in the re­cent past. All in all, the cur­rent bal­ance be­tween cycli­cal and fi­nan­cial con­di­tions does not sig­nal a pro­longed weak­ness in Euro­pean eq­ui­ties. Yes, frus­tra­tion about the eu­ro­zone’s eco­nomic per­for­mance, in­vestor im­pa­tience over earn­ings growth, and con­cerns about ten­sions with Rus­sia might leave eu­ro­zone mar­kets look­ing vul­ner­a­ble in the near-term, es­pe­cially with Wall Street’s volatil­ity ris­ing. But we still rec­om­mend buy­ing the dips in ex­pec­ta­tion of a bet­ter fourth quar­ter, when the un­cer­tain­ties sur­round­ing the ECB’s As­set Qual­ity Re­view will have been set­tled. Mean­while, con­tinue sell­ing the euro as a hedge.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.