Robust Europe
In Europe, the macro picture remains robust. Monetary indicators are all positive: lending to the private sector rose to 1.7% year on year in July, which is the highest rate of growth since 2011. Loan maturity is also increasing, which, coupled with survey evidence, may suggest that this borrowing will be used for investment rather than for financial engineering.
Labour market and consumer indicators are also strong, relative to the past five years, and have remained so since their dramatic recovery in Q4 2015. Consumption growth has recovered to pre-crisis levels. So why are we underweight?
Current valuations do not offer enough compensation for the elevated risks to earnings growth. When one discards the cheapest and richest sectors, eurozone equities are more expensive than the FTSE and not far behind the US. Similarly, the equity risk premium, while elevated, is not as far above its long-run average as in the UK or the US.
A loss for Italian prime minister Matteo Renzi in the constitutional referendum in November could throw Italy into an existential crisis, delay the essential restructuring of its banking sector and place Italy at loggerheads with the eurozone establishment.
If the Italian leadership loses the support of the eurozone institutions, the entire region could suffer a loss of confidence. And investors should be only too aware how episodes of acute equity market stress in Europe have coincided with political events during the past few years.
Japan in the driving seat
Turning to Japan, we believe the four key secular drivers behind Japan’s outperformance are still intact:
A radical improvement in return on equity due to improved corporate governance.An increasing shareholder focus will lead to return of cash mountain by way of dividends and buybacks.A huge potential for multiple re-rating as pension funds (and now the Bank of Japan) allocate to equities.Potential for multiple re-rating as positive inflation expectations and a hunt for yield leads households into equity ownership.
Even as stock prices struggled this year, operating margins came back strongly in Q2, while buyback announcements continue to smash last year’s record-breaking highs.
Yet we cannot escape the fact that the macro environment continues to deteriorate, eroding market sentiment. Japanese earnings breadth and the momentum of analysts’ revisions were stronger than any other major market over the past two years but this has fallen into negative territory.
Headline inflation has fallen sharply to -0.5%. Although core inflation is still at +0.8% and the highly regarded Hitotsubashi CPI has plunged from +1% at the start of the year to -0.3%. Worse, inflation expectations have fallen to a four-year low.
Although they remain positive, which for Japan is still quite something, it is concerning, given that smashing the deflationary mindset once and for all is essential if president Shinzō Abe and Bank of Japan governor Haruhiko Kuroda are to succeed in reigniting the country’s new economy. We remain positive on the market, with a modicum of caution.
