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December 10, 2015

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Euro area stands out for equity investment

By Steve Brice | December 10, 2015, Thursday | Print Edition

THE volatility in recent months shattered the relative calm that had prevailed in global financial markets for nearly four years. Almost all major equity markets corrected more than 10 percent during the summer, and many emerging markets entered a bear market.

What to expect from here?

To allay the biggest fear first, we do not believe the recent volatility was a precursor to a prolonged bear market in the developed economies. Typically, bear markets come with recessions and there are no signs of a recession unfolding in the US or Europe in the next 12 months.

Meanwhile, low inflation due to falling commodity prices means monetary policy in developed markets is likely to remain highly accommodative well into next year and possibly beyond.

Against this backdrop, we believe the euro area stands out as a destination for equity investments for three reasons:

Earnings growth in the euro area is expected to far exceed those in the US and UK, backed by improving margins that are getting a boost from rock-bottom raw materials and borrowing costs. Meanwhile, the weak euro is boosting exporters.

The smaller share of commodity companies in the Euro area makes the region relatively attractive, given the bearish outlook for energy and materials. Euro area equity valuations are cheaper than those in the US. Let’s look at these factors in more detail.

Earnings growth in the euro area

Earnings growth in euro area companies is forecast to grow about 12 percent in the next 12 months. That’s faster than the 7 percent growth expected in the US and the 2 percent expected in the UK. The main driver is falling raw materials and borrowing costs, which are helping boost corporate profit margins.

The European Central Bank (ECB) has forced down borrowing costs to record lows. Lower input and borrowing costs have helped corporate profit margins recover from 2008 lows. While euro area margins remain below the 10 percent recorded in the US, they are expected to expand further, whereas US margins may have peaked.

Meanwhile, the ECB’s accommodative monetary policy has helped weaken the euro almost 30 percent against the US dollar since the financial crisis. This is a windfall for euro area exporters, particularly in the industrial and consumer sectors because it gives them a competitive edge against other exporting economies. Today, almost 55 percent of the euro area’s corporate revenues come from outside the region.

Smaller share of commodity companies

In our view, euro area stocks are appealing, especially compared with the UK, due to their relatively lower exposure to falling commodity prices. Energy and materials sectors account for only 13 percent of the stocks in the euro area’s stock index, compared with 20 percent in the UK. In the US, the share of the commodity sector in the benchmark S&P500 index is 11 percent. As a result, euro area corporate profits are likely to face less of a drag from continued declines in oil and metal prices.

Equity valuations are cheaper

Equity valuations in the euro area are cheaper than those in the US and UK, despite the region’s companies reporting faster earnings growth.

The improvement in euro area margins is also supportive of higher valuations. Dividend payout ratios have declined in recent years, largely because of reduced payouts from financial sector companies. We expect that trend to reverse as banks recover from the euro crisis of the past few years, which, in turn, should boost euro area stocks.

Robustness against risks

With the Greek crisis tackled, the main risks to the outlook for euro area equities come from outside the region. The region is more exposed to the US and UK – among the more robust of the world’s economies today — than to other parts of the global economy. This should provide resilience to euro area corporate earnings. We do not expect the recent terrorist attacks in Paris to materially affect consumer sentiment.

A reversal in the euro and tightening of monetary conditions are other risks. However, these risks are likely to surface late in 2016 or later. Until then, euro area stocks are likely to provide among the best returns globally.

 

Steve Brice is the chief investment strategist at Standard Chartered Bank’s Wealth Management unit. Shanghai Daily has condensed the story.

Biz Special


 

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