There is little doubt that Japanese and European equities were the standout favourite markets with professional investors heading into this year.
The reasons were simple – they had both lagged and were trading at a discount to the US, there were signs of an improvement in the underlying economic fundamentals and, most importantly, both regions’ central banks were expected to fire huge amounts of quantitative easing (QE) in the market.
The Bank of Japan had already committed to its stimulus programme and the European Central Bank (ECB) duly followed in the spring with its own QE programme.
Of course, it’s not been a smooth ride, but investors have largely been rewarded for backing Japan and European funds. According to FE Analytics, the MSCI Europe ex UK and Nikkei 225 have outperformed the MSCI AC World in 2015.
Performance of indices in 2015
Source: FE Analytics
On top of that, 10 of the top 15 performing funds in the Investment Association universe sit either the IA Europe ex UK, IA European Smaller Companies, IA Japan or IA Japanese Smaller Companies sectors.
Interestingly, not much has changed in terms of people’s outlooks for the year ahead with Japan and Europe by far and away the most popular equity regions with investors for 2016. Here, we take a closer look why.
Japan
First up is Japan, which has seen some significant changes over the last three years under prime minister Shinzo Abe.
His policies, which have been dubbed ‘Abenomics’, were very successful in the early stage as his first two ‘arrows’ of fiscal and monetary reform saw the yen weaken considerably and the equity market soar.
Performance of indices since Abenomics
Source: FE Analytics
However, the falling oil price has pushed Japan back into deflation and some have started to question the effectiveness of the government’s third arrow of structural reform.
Nevertheless, with the Bank of Japan providing such huge amounts of liquidity and changes happening at a corporate level, Fidelity’s Nick Peters is confident Japan will be one of the most attractive markets in 2016.
“Japan is starting to recover from an economic malaise that has lasted a generation. A development of that magnitude in a country of Japan’s size, with a deep and liquid stock market, is a rare and exciting prospect offering sustained upside – perhaps akin to the rise of post-reunification Germany,” Peters said.
“Japan is certainly competitively valued compared to other developed markets. At 13.99, the P/E ratio is lower than that of the UK or the US. While emerging markets offer a lower P/E ratio of 10.94 times, this region also faces significant headwinds, including dollar strength, commodity price weakness and a slowing China.”
“In contrast, many of the trends affecting emerging markets actually benefit Japan such as the stronger dollar boosting demand for Japanese exports. While falling commodity prices complicate the Bank of Japan’s attempt to raise inflation expectations within the country, Japan does benefit as a net importer of commodities.”
FE Alpha Manager Chris Taylor, manager of the Neptune Japan Opportunities fund, is also positive on the region.
He says from an economic perspective, no VAT increase until 2017, the huge falls in the oil price and wage rises will all support growth. From a market point of view, he says it looks even better.
“Given the one-off nature of the factors favouring the defensive and domestic sectors, the global economy should finally in aggregate be benefiting from cheaper energy,” Taylor said.
“Accompanied by further measures to weaken the yen, we expect corporate profits should continue to rise. However, momentum should swing back to the large, multinational firms, particularly the manufacturers.” 
Darius McDermott (pictured), managing director at Chelsea Financial Services, is also bullish on Japan and cites it as one of his favoured markets for the year ahead. However, he is keen to point out that strong market gains are by no means a sure fire bet thanks to issues such as its huge demographic problem.
“Companies are even arranging dating events for employees or giving financial rewards to have kids. And the fastest growing band of criminals are the over 65s – as the standard of living in prisons is better than at home,” he said.
Government debt also stands at an eye-watering 240 per cent of GDP. The only good news on this is that a lot of it is domestically held and, as suggested by one industry expert recently, once the government owns more than 50 per cent of it (at the current rate of purchase that will be around 2018), it could convert it into ‘perpetual zero coupon bonds’.
“And then there is China. China has a much bigger impact on the Japanese economy than many people assume. So all eyes on the Asian Dragon,” McDermott said.
Europe
Having been the perennial source of bad news for global markets, Europe has quickly turned into one of the most popular markets among investors.
Improving economic conditions, attractive valuations (relative to the US) and very accommodative policy from the ECB has meant investors have largely been positive on the region for some time, but 2015 has been a rocky road for European equities thanks to macro headwinds such as concerns surrounding emerging markets and Greece’s debt negotiations.
Trevor Greetham, head of multi-asset at Royal London, says the macroeconomic backdrop makes Europe his favoured region for 2016.
“Euro area growth could surprise positively with the monetary base and credit measures expanding rapidly, even before the European Central Bank increased its stimulus,” Greetham said.
“Even China could see better activity as various monetary and fiscal easing measures take effect. In this scenario we would expect to see a series of Fed rate hikes and an increase in volatility in the financial markets. Commodities and emerging markets could rebound as bond markets sell off. European equities look well placed either way.”
However, Dean Tenerelli, portfolio manager of the T. Rowe Price European Equity and Continental European Equity funds, strikes a more cautious tone.
He points out that given valuations have increased as a result of the rally in European equities since ECB president Mario Draghi’s “do whatever it takes speech” in the summer of 2012 and increasing global concerns, he says investors shouldn’t get too carried away.
Performance of indices since Draghi’s “do whatever it takes” speech
Source: FE Analytics
“When viewed in simple P/E ratio terms, based on the next 12-months earnings, European valuations are starting to look reasonably full, trading near long-term averages. This reflects the gains we have seen over the past 18 months as the market has started to price in European recovery,” Tenerelli said.
“However, on a cyclically adjusted P/E basis, the picture looks quite different, suggesting valuations remain low relative to long-term average levels and still some 20 per cent below the peak earnings levels of 2007.”
That being said, the manager still expects further gains from the asset class – although volatility is likely to persist as it has done in 2015.
“However, tempering this expectation is the moderation in global growth that we have seen in recent months. While for some time a growing global economy has been a supportive tailwind, it now represents a negative in terms of corporate earnings prospects, both in Europe and globally.”
His thoughts are echoed by FE Alpha Manager Barry Norris, who heads up the FP Argonaut European Alpha fund.
“We continue to believe that the most powerful equity narrative is the recovery of domestic Europe and, in addition, continue to find attractive idiosyncratic earnings surprise in single stocks,” Norris said.
“Somewhat ironically, given long-term scepticism of European equities, the biggest risks are now all exogenous: the Chinese economy, Fed funds and commodities. However, contagion threats should be limited by the delay of or even addition to monetary stimulus in Europe.”
“As such, although volatility may remain elevated for a period of time, we remain confident in our fundamental positioning and see compelling opportunities on both sides of our book.”
