Investors should not lose faith in the recovery of the Japanese and European equity markets because of their recent weakness, according to Pictet Asset Management chief strategist Luca Paolini, who says valuations and corporate profit forecasts are two of the reasons these equities will beat any other.
In the first three months of the year investors in Japanese and European equity funds saw a pleasing rally in both markets. By mid-April the average fund in the IA Japan and IA Europe ex UK sectors returned nearly 20 and 14 per cent, respectively.
However, the rally has not lasted and anyone investing around this time in either sector would be sitting on a double-digit loss, taken on average.
Performance of sectors in 2015
Source: FE Analytics
The respective rallies were prompted to a large degree by the announcement of quantitative easing by the European Central Bank and Bank of Japan. But a broadly risk-off period since April and lower inflation expectations from both central bank have taken the shine of their recovery, while Europe had the added concern of the Greece debt crisis.
However, Paolini says the two equity markets currently offer the best value above any other within either the developed or emerging equity space.
“European and Japanese equities remain our favoured markets, partly on valuation grounds but also because corporate profits appear set to grow faster in these regions than in other areas of the world,” he said.
“European stocks look particularly attractive. Company earnings are currently rising at an annualised rate in the low single digits but the pace could quicken for a number of reasons. The first is a supportive central bank.”
“The ECB ultra-loose monetary policy has translated into a burst of consumer spending, shielding the region’s companies from China’s slowdown and helping the eurozone economy grow for nine quarters in a row.”
“Also helping corporate Europe is the combination of a weak euro and low oil prices, which should have a positive effect on profit margins. Corporate profit margins in Europe are more or less in line with the long-term average which, when seen in the light of a recovering economy, suggests there is plenty of scope for them to expand.”
Russ Koesterich (pictured), BlackRock’s global chief investment strategist, thinks European equities could also stand to benefit from a weak inflation data, which may prompt further quantitative easing by the ECB.
Paolini says that Pictet’s own forecasts for continental European corporate profits predict a rise of about 10 per cent over the next 12 months, with those in the financial sector leading the way.
The average fund in the IA UK Europe ex UK sector is underweight financials but 45 per cent – or 49 out of 108 funds – have an overweight. The biggest bull on financials is the £533m Neptune European Opportunities fund, managed by FE Alpha Manager Rob Burnett.
Burnett has built up to about 37 per cent in financials this year, which is the largest weighting he has had for at least three years, in names such as BNP Paribas, UniCredit and Banco Poplare Societa Cooperativa.
Paolini added: “Valuations for European stocks also look reasonable. On measures such as price-earnings and price-to-book ratios, European equities trade at a 10 per cent discount to both their US and global counterparts.”
Our data shows that Europe has become very popular with fund managers running global portfolios. The average weighting to Europe has increased in the IA Global sector to 17.7 per cent, its highest since the April sell-off.
The average weighting to Japan has also gone to a three-year high in the IA Global sector to 7 per cent, on average.
Japanese companies, Paolini says, have much like their European peers been beneficiaries from a weak currency, which has improved their global competitiveness.
The yen is almost 20 per cent cheaper compared to the dollar than it was two years ago and 15 per cent cheaper against sterling.
Performance of yen versus US dollar over 2yrs
Source: FE Analytics
This has the effect of making Japanese exports cheaper than rivals firms in the US or UK, boosting the revenues of the firms that produce them.
“A weak yen should continue to be a feature of the financial landscape given the Bank of Japan’s ultra-loose monetary policy,” Paolini said.
“At the same time, thanks to improvements in corporate governance, companies are making more efficient use of their balance sheets, which holds out the prospect for a steady increase in the market’s return on equity.”
“Corporate profit margins are also on the rise. None of these developments appear to be reflected in the valuations for Japanese stocks which, on a price-earnings basis, trade at an 8 per cent discount to the MSCI World Index.