October 2017- European Value strategy: outlook & positioning

271017 Market Commentary

October 2017- European Value strategy: outlook & positioning

Market environment & outlook

 
“It’s the economy, stupid!”
  James Carville was famously right focusing Bill Clinton’s presidential campaign in 1991 around this catchy campaign slogan. In the end what moved the US voters at that time was not the military successes in Iraq of the Bush administration but mainly the dire state of the US economy. We believe exactly the same applies to the financial markets. What is key for long-term equity markets return is the state of the economy; the other events can be considered short-term noise! Translated to the current situation in Europe, it means that, when analysing the long-term potential of the stock market, we have to avoid being overly influenced by the (geo)political noise (US/Korea tensions, German elections, etc.) in order to focus on what is currently driving the financial markets: a booming economy. And yet, European economies seem to be on the right track for a sustainable recovery. It is not only the leading indicators (like PMI, etc.) that are pointing towards a stronger economy but also real economic statistics that are showing improvement as illustrated by the evolution of industrial production in the below chart Source: Bloomberg, Eurostat industrial production Eurozone, 31/07/2007 to 29/09/2017.  
Earnings growth is entering the game…
  For many months now, we are claiming that a healthy European equities rally cannot occur without a sustainable recovery of companies’ earnings. In our Q2 report we were confident to see more and more evidence of this recovery happening in 2017. That appears to be materially different from previous years where market expectations for earnings growth started high but needed to be constantly revised downwards as the investment community needed to adapt to weak corporate profits. Hence, the trend seems to have reversed with upward revisions occurring very recently. Source: IBES, MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management.  
There are little alternatives to equity markets
  Yes, we are clearly talking our book here… but there are objective elements supporting our view! To us, in the current context, equity markets are one of the few alternatives available to generate some yields. Honestly, a German 10-year Bund at 0.45% does not look particularly compelling while credit spreads are at historical lows. Within the asset class, Europe remains the obvious region to favour; European markets are no longer cheap but still they are not looking particularly expensive compared to their peers and, when looking at the LT Shiller PE ratio, which is one of our favourite measure. Source: IBES, MSCI, Thomson Reuters Datastream, J.P. Morgan Asset Management.   Moreover, given the apparent hesitation of the ECB to withdraw its extraordinary expansion measures, the risk of a hawkish interest rate move is, from our point of view, still limited. However, the market global low volatility should not make us complacent and fall asleep at the wheel. Trading volumes are low and we experience on a daily basis that, under the surface, on the individual stock level, market reaction can be violent. Indeed, it is not rare to see stocks going down by 5% or more on a sole downgrade by a sell-side analyst. These excesses create underlying volatility but also offer opportunities for long-term oriented stock pickers like us.   Finally, despite a slight rebound in flows since the beginning of the year, European equities remain an under-owned asset class and equity flows are still lagging the improving growth outlook. This situation will normalised as market participants will gain confidence in the strength of the economic recovery.  
Where are the risks?
  As detailed above, we do not see political noise as a major medium-term threat for the financial markets. We remain concerned about every factor that could affect the operating environment of our companies and currently, our main apprehension is probably the impact of the USD depreciation on European exporters. In addition, even if it is not our main scenario, a sharp increase of interest rates would obviously be detrimental to equity markets.