JPMorgan’s equity strategist team has published a report today trying to figure out if European stocks will finally break out the glassdoor of 400 points (for Stoxx Europe 600) that they have been hitting 3 times already (2000, 2007, 2015).
They argue that this time might be the time, IF a number of conditions are successfully met. Among them, earnings recovery, operating leverage, decent (!) valuations and direction of bond yields are important factors to consider. Big swing factor are FX.
Probably the most important and the one factor that has truly be the missing one so far is earnings growth. Well 2017 has been a good year for once, but the momentum has to keep up when you consider what a laggard European earnings have been compared to the rest of the world.
Per above chart, European EPS are 16% below their previous peak while MSCI World EPS have move forward already, thanks in large part to the US and EM.
The good news is that after a series of false starts, the economic recovery in Europe is finally ongoing. So far, nothing, not even Brexit, has dented it.
Yet all European stocks are created equal when it comes to EPS growth. Per above chart, commodities and domestic sectors are the one that have lagged in terms of earnings recovery.
Domestic sectors such as Telcos, Utilities have been affected by the lack of economic growth, capital investment and consumption growth and also the pressure on public finances in a number of countries after the Eurozone crisis.
But Financial also have been affected by lower bond yield, disruption in the industry, such as regulatory pressure (Basel 3, 4… Solvency… MIFID…) and technology innovation.
JPM’s view in a couple of points:
« 1. Earnings are needed to deliver, as poor profitability was a major drag on Eurozone performance in the current upcycle. This is changing for the better. Eurozone earnings typically have 5-6x beta to GDP and our economists are calling for as much as 2.9% Eurozone GDP growth this year. Therefore, consensus earnings expectations should be surpassed for a 2nd year in a row.
2. Valuations are not demanding. Both the SXXP P/E and P/B multiples relative to the World are currently lower than at each of the past 3 peaks, in fact showing 2x the average discount seen at the last three market tops. Broken into countries, the biggest valuation discount is offered by Italy and Spain, and the smallest by Switzerland.
3. The direction of bond yields is very important for the Eurozone performance, as it drives a potential style shift, out of Growth and into Value, which Euro area is significantly exposed to.
4. Fx is a wild card. Current US fiscal deficit of 4% in the 10th year of the upcycle is a huge contrast to late 90-ies episode where US enjoyed outright surplus. If US were to have a downturn over the next 2-3 years, the budget deficit might really shoot up. Consequently, the USD could weaken further and were this to materialize the strong Euro could take away some of the upside in SXXP. Still, we think that equities will not be completely dominated by stronger Euro as it is in part a reflection of the accelerating activity, but maintain a preference for domestic plays over exporters. »
IMHO, the point on European stocks valuation is debatable. Most of the argument of JPM is to compare European stocks valuation relative to US. But if the US equities have outperformed Europe, it’s mainly because of earnings growth which has been the main driver in the US up till last year.
Yet if you look at the absolute valuation level of European equities, the impression is more that they are at fair value, not underpriced.
Another point is the fact that US stocks are much more in late cycle configuration than Europe. If the US equity market were to correct and fall significantly, even better fundamentals might no suffice to protect European equities. They would go under like the rest of the world. That’s also one risk factor to consider, as well as China leverage.