Earnings recovery should support further stockmarket gains in 2016. Careful stockpicking will be needed as correlations within markets are likely to unwind.
At the time of writing, the MSCI Europe equity index has delivered a total return of around 10% this year and we believe investors should see further gains in 2016 given the continued earnings recovery in Europe.
Scope for profit margins to improve Corporate profit margins within the eurozone particularly remain at depressed levels relative to the US. This gap has been significant since the global financial crisis and a narrowing of the disparity would support European equities. At the same time, valuations are compelling versus historical levels and most other equity markets.
Chart 1: Trailing 12 months net profit margin % Chart 2: Cyclically-adjusted price to earnings ratio
Source chart 1: Bloomberg, as at 31 October 2015 Source chart 2: Thomson DataStream, Schroders, as at 31 October 2015
Stock selection crucial as correlations unwind Whilst we are constructive on European equities overall it is probable that there will be significant differences in terms of thematic and sector leadership. Correlations within equities have increased markedly since the summer when the Chinese devalued the yuan and intervened in the stockmarket. A possible US rate increase and concerns about a hard landing for the Chinese economy triggered a market sell-off across asset classes which reflected a ‘risk-off’ period of uncertainty. We believe the opportunities within equities for 2016 will require careful stock selection as correlations unravel, leading to more differentiation between stocks and greater opportunity to generate alpha.
Chart 3: Corrrelations increased in 2015
Source: Schroders, Bloomberg. Based on the Eurostoxx 50 index. as at 31 October 2015
In both the fixed income and equity markets, ‘quality, safe’ assets have seen a period of strong outperformance to the extent that the defensives versus cyclicals are back to levels seen through the eurozone crisis. Corporate bond yield spreads have significantly widened versus government debt despite the global deflationary pressures. These moves indicate nervousness across markets that the global economy may be entering a more difficult period. We would agree that the global economic outlook is more uncertain but the extreme moves we have seen in ‘growth versus value’ have opened up valuation anomalies as indicated by the chart on price/book value below.
Chart 4: World Growth vs Value return Chart 5: Price to tangible book ratio
Source chart 4: Thomson DataStream, as at 31 October 2015 Source chart 5: Schroders, Bloomberg, as at 31 October 2015
Eurozone recovery has momentum From an economic perspective we are confident that the eurozone recovery will continue through 2016 despite the emerging market turmoil witnessed during the late summer. The export market is clearly suffering but overall the data suggest to us that the eurozone economy has momentum in its recovery phase driven by domestic demand, credit expansion and consumption growth. It’s worth noting that services and construction make up 75% of German GDP and these areas of the economy are performing well. The same can be said for other large eurozone member countries.
Chart 6: Eurozone growth shows better momentum Chart 7: Credit cycle
Source chart 6: Thomson DataStream, Markit, Schroders Economics Group, as at 23 September 2015 Source chart 7: Thomson DataStream, as at 30 September 2015
The eurozone can also count on the ongoing support offered by the European Central Bank’s (ECB) quantitative easing (QE) programme. Recent surveys from businesses and consumers show that QE is having a positive effect on credit growth which is crucial if economic expansion is to be maintained. Additionally, ongoing QE will help keep the euro under pressure, especially if the US Federal Reserve does decide to raise interest rates. There could be more easing on the way in the eurozone: Mario Draghi recently warned that global forces may have a negative impact on GDP growth and suggested that further measures could be announced imminently. In summary, we see a positive outlook which is likely to be enhanced if the ECB takes further policy action.
Past performance is not a guide to future performance.
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