Japanese and in European equities could offer up the best investment opportunities in the coming months, according to the latest quarterly investment outlook from Rathbones. 
However, the Rathbones analysts are more cautious in their outlook for the second half of this year for technology valuations and the challenges posed by the UK’s exit from the EU.
In Japan, the analysts are constructive for the prospects for Japanese equities during the latter half of the year, as prime minister Shinzo Abe continues to enact economic reforms.
"Abe’s ‘Abenomics’ strategy comprises three arrows: monetary stimulus and currency devaluation to achieve a 2 per cent inflation target; a flexible, stimulatory fiscal policy; and a growth strategy focusing on structural reform to increase capital and productivity,” the analysts noted.
“There has been widespread disappointment regarding prime minister Shinzo Abe’s fiscal and monetary policies with doubts about the impact of aggressive monetary easing plans to boost growth through increased government spending.”
The third arrow of Abenomics comprises structural reforms to Japan’s inefficient agriculture, healthcare and labour markets, and this is where the Rathbones analysts see progress.
“In this area, there continue to be signs of success with improvements in corporate governance and initiatives to attract more women and foreign expertise into the workplace,” the analysts said.
Indeed, as the below chart shows, since Abe took charge in 2012 return on equity has risen by more than 3.5 percentage points as companies have focused more on returns for their shareholders.
Return on equity since 1990
Source: Rathbones
“Although Japan still has catching up to do, many companies are committing to return on equity targets for the first time,” the report highlighted.
From a data perspective, the market is up 5.66 per cent so far this year with a weaker yen providing a tailwind to exporters.
Meanwhile, the pace of economic growth is a little better and inflation has also picked up slightly, while Japan’s workforce is rising despite an ageing population.
“We believe Japan remains an interesting investment story for the long term, providing a degree of diversification from other developed markets,” the analysts wrote.
Another area of note for the firm is in Europe, which has experienced new-found popularity this year as political tensions have been subdued by both the Dutch and French election results.
“Emmanuel Macron’s victory has staved off investor fears about populism, while fundamentals are improving. In 2016, the region expanded faster than the US for the first time since the financial crisis,” the Rathbones investment team said.
Indeed, the recent macroeconomic data has been better than it has been for a number of years, with the pace of growth improving in the region, while company earnings expectations are not being revised down as aggressively as they have been in the past either, the report said.
“The purchasing managers’ index has reached its highest level in six years, the unemployment rate has fallen to 9.3 per cent, its lowest level since 2009, and the euro has made gains against the US dollar,” the team noted.
As such, investors have been turning away from ‘expensive’ US equities in favour of their European counterparts, the report said. European exchange-traded funds (ETFs) netted a record $6.1bn in inflows during the first week of May.
Indeed, as the below graph shows, Europe has lagged the US for much of the past decade but has come on strongly so far this year and was the best performing developed market in the first half of 2016.
Performance of indices over 10yrs
Source: FE Analytics
However, the Rathbones quarterly investment outlook observed that European stocks are no longer cheap thanks to the most recent rally.
“The headline P/E [price/earnings] ratio for the MSCI Europe index now 24.3x compared with 21.7x for the S&P 500,” the report said.
“We believe investors should be wary at the top end of the market-cap spectrum where ETF flows tend to be concentrated.”
This, coupled with headwinds including political uncertainty in Italy and ongoing Brexit negotiations mean the team remain wary of the area.
“We remain cautious and continue to favour quality companies and fund managers with a proven track record,” the investment team said.
The team are also nervous on the UK prospects thanks in part to the ongoing Brexit negotiations and increasing inflation expectations.
“After failing to win a majority in the general election, the Conservative party have formed a working agreement with the Democratic Unionist Party,” the report said.
“This adds to the uncertainty with negotiations over leaving the EU now under way,” it noted, adding that changing expectations for Brexit negotiations could increase the risk of downward revision for UK growth forecasts.
Inflation is now more than offsetting wage growth as sterling weakness drives up import costs, the Rathbones investment team said, putting pressure on the domestic economy.
“A dramatic fall in household savings and increased borrowing raise some concerns about the outlook,” the report said.
However, the fall in sterling has benefited the FTSE 100 index, which is made up of more internationally-facing exporters, making some parts of the market attractive to investors.
“With most revenues for the FTSE 100 index generated abroad, the weaker pound has increased the value of earnings for sterling investors,” Rathbones investment team said.
“The FTSE 100 continues to outperform the more domestically focused mid-cap FTSE 250 Index, but still trades on a lower P/E.”
This has led to a divergence in sector performance: “For example, results from UK retailers have been poor as customers’ real wages are being squeezed and many end-products are made overseas.”
The final area that has raised concerns for the team is the technology sector, particularly in the US, where valuations appear extremely high.
Indeed, as shown below, the S&P 500 technology index has far outstripped the main market over the last half-decade pushing valuations to new highs.
Performance of indices over 5yrs
Source: FE Analytics
The tech sector now represents just under a quarter of the entire S&P 500 with the five biggest US companies – Apple, Alphabet, Microsoft, Amazon and Facebook – making up 13 per cent of the index.
“These ‘big five’ have built up significant cash piles. For example, Apple’s cash represents nearly 22 per cent of its market value,” the report said.
“Cash allows them to acquire other companies to gain expertise, technology or market positioning to accelerate their growth.”
While the report noted that diversity in the sector means the overall valuation is “not excessive” and that the S&P 500 IT subsector trades at a much lower P/E multiple than it did at the peak of the technology boom in 2000, the sector remains expensive relative to the index.
“After such strong performance, the sector may be due a pause or correction as investors take profits and reassess the upside,” Rathbones investment team said.