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Europe Downgrade: An Unhealthy Combination Is Brewing
May 20, 2016

While the prospects of the Eurozone economy remain fair, market valuations have prompted us to downgrade our rating on European stocks on the back of a sharp rebound in prices: higher prices and lower estimated earnings are not a good combination.


Author : iFAST Research



 Europe Downgrade: An Unhealthy Combination Is Brewing
On 28 April 2016, we downgraded 3 markets under our coverage: US, Europe and Brazil, following what was a short lived upgrade on 12 February 2016 of both the US and Europe. Focusing on Europe, we had upgraded our rating on the continent as we felt that investor sentiment had been overly negative towards European equities, which as a result saw the expected annualised contraction in valuation multiples that we had cautioned on for some time pan out, leaving the valuations for European equities at its lowest since July 2013! In addition, we noted that the Eurozone economy was looking to continue its slow but steady growth path, and that the latest policy measures by the European Central Bank did look promising for the single currency union.

Given the above, investors might be wondering why we're downgrading the market since we appear to be comfortable with the economic prospects of Europe. When assessing the attractiveness of a potential investment, one should consider both the prospects of the underlying economy as well as the valuations of the asset. While the prospects for the underlying economy (the European economy) appear to be fair, it is the valuations of the market that have prompted us to downgrade the market.

Following what was a horrendous start to a year that saw the MSCI AC World mark its third-worst January ever, global equity markets have since staged a sharp recovery, with European equities posting returns of +11.7% (in EUR terms) following our upgrade of the market till 28 April 2016. Unfortunately, the sharp rebound that has been seen in share prices has yet to be witnessed in the earnings estimates for European companies, which have actually continued to be downgraded by consensus. The combination of both higher equity market prices and lower estimated earnings have seen the Price-to-Earnings valuation measure rise significantly.

In this article, we present a brief update on the underlying economy as well as the current forecasted returns projected for European equities.

The Underlying Economy

As has been the case for the past year, leading indicators have been pointing towards the Eurozone economy continuing to expand at a modest pace. With the various readings of the Purchasing Managers Indices (PMIs) as well as sentiment indicating that despite a recent deceleration in the pace of growth as compared to that which was seen in 2015 (Chart 1), economic growth in the Eurozone is still expected to be positive in 2016. In addition, the various sentiment surveys have also displayed signs of stabilisation following a rather volatile 2H 2015 and 1Q 2016 which saw both financial markets as well as sentiment affected to the downside (Chart 2).

Chart 1: PMIs Still Indicating Expanding Business Activity

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Chart 2: Sentiment Indicators Stabilising

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The relative resiliency of the Eurozone has been reflected in the latest advanced GDP figures, with the Eurozone economy actually posting a slight acceleration in economic growth. 1Q 2016 GDP figures recorded a growth rate of 0.6% on a quarter-on-quarter basis, accelerating from the 0.3% seen in 4Q 2015 and beating consensus estimates of a 0.4% rate. On a year-on-year basis, the continent's economy grew by 1.6%, matching 4Q 2015's rate while beating estimates of a 1.4% reading. Comparing the region's growth rate against the other developed regions, it is interesting to note that the Eurozone's 1Q 2016 GDP growth was stronger than that seen in the US (+0.5%) on a quarter-on-quarter basis, a major regional market that many consider to have a sustainable rate of growth. While the latest economic growth rates are welcomed, we think that the potential for further positive surprises exist as the European Central Bank's monetary easing policies begin to filter through the economy and make their effects more acutely felt over time.

Chart 3: Economic Soft Patch Over?

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Heady Valuations & Declining Earnings

While prices have risen sharply, contributing to most of the higher Price-to-Earnings ratios, the continued downgrades to earnings have also played a part. Since our upgrade of the market, earning estimates for the Stoxx 600 have been downgraded by a further -3.6% (as of 28 April 2016), with aggregated earnings growth for the benchmark now expected to be –3.5% in 2016 with 2017 expected to see a rather large rebound of 13.7%. The expected contraction in earnings for 2016 will be the first time since 2013 that the index is expected to post lower earnings. Drilling down a bit further into the earnings of the index, we note that the largest declines in earnings are expected to come from companies in the Oil & Gas, Basic Resources as well as Bank industry groupings. If one were to remove these 3 industry groups, then the Stoxx 600 would actually be looking to post earnings growth of 2.3% instead of the -3.5% the index is currently staring at for 2016.

Chart 4: Earnings Forecasts

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While we are aware that corporate earnings are expected to post a slight contraction in 2016, there is the possibility that consensus has been overly-bearish on the prospects of European corporates, with the potential for upward revisions if no crisis or doomsday scenario materialises.

With an estimated PE of 16.0X and 14.1X based on 2016's and 2017's estimated earnings (as of 28 April 2016), investors today are indeed paying a premium against our estimated fair value of 13.5X PE for European equities. The region is no longer as attractive as it once was two months ago to us given the run up in valuations, particularly with an annualised potential -8.7% contraction in the valuation multiple by end 2017 is now on the cards. Forecasted returns for European equities are now projecting an annualised 1.2% return by end 2017. Thus, the combination of higher prices and lower estimated earnings, in itself never a good combination, has seen the forecasted return of European equities decline significantly and reduced our positivity on the region's equities.

Chart 5: Valuations Were Once Cheap

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Chart 6: Expected Valuation Contraction To Detract From Total Returns

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Conclusion

While we retain our positive outlook for the Eurozone economy, equities have appeared to have yet again gotten ahead of themselves, prompting us to reduce our star rating on European equities from a 3.0 Star "Attractive" to a 2.5 Star "Neutral" rating.

As for investors looking to add exposure to the region, we advocate the utilisation of a dollar cost averaging approach should they seek to gain or increase exposure to Europe as it would allow one to potentially average in at lower prices.

Rather than chasing the market higher, we believe investors' attention should be focused on markets such as the Asia ex Japan regional market, China and Hong Kong which we continue to find more attractive and which sport much higher expected returns for investors. The three markets have a 5.0 Star "Very Attractive" rating.


Disclaimer: iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's scheme information document including statement of additional information. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer on the website.Please read our disclaimer in the website.



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