11th February 2013
Fund flows continue to move into equities with $9.3 billion allocated to open-end mutual funds last week, down from $13.4 billion in the prior period. Emerging market equities have captured over half the flows year-to-date even though assets invested in emerging markets are just 10 per cent of the total. Flows to developed markets have been largely to global funds, and US-focused funds have attracted about twice as much as dedicated European funds.
Fresh cash should support markets, but ultimately it is a combination of earnings growth and valuation that will determine investor returns. Results for US companies in the current earnings season continue to be modestly positive. The headline growth rate for earnings looks impressive at 11.3 per cent with 341 companies reporting, but the figure is flattered by an extraordinary jump in earnings for financial stocks which does not reflect underlying trends. Excluding financials the growth rate drops to just 3.9 per cent. (see Figure 1).
Figure 1: S&P 500 earnings growth year-on-year, 4q12
Data as at 9 February 2013. EGY = Energy, MAT = Materials, IND = Industrials, C D = Consumer Discretionary, C S = Consumer Staples, HLT = Health Care, FIN = Financials, I T = Information Technology, TEL = Telecom Services, UTY = Utilities, SPX = S&P 500, xFIN = excluding Financials. Source: Bloomberg, J.P. Morgan Asset Management.
As low as this value is, it is still better than what has been generated by companies in Europe. For those that have reported quarterly or semi-annual results, earnings growth is negative year-on-year. The short-term challenges faced by corporations in Europe do not mean, however, that investors should not be looking to increase their allocations to equities in the region. The global financial crisis and recession arrived in Europe after it did in the US and so the recovery has been similarly delayed. Economic growth should be improving in 2014, however, and earnings forecasts reflect that. For the next couple years, analysts expect growth to be on par with that of US companies (see Figure 2).
Figure 2: Annual earnings growth (MSCI indices)
Latest data 9 February 2013. Source: MSCI, Bloomberg, J.P. Morgan Asset Management.
Better valuations in Europe than in the US are another reason to be allocating to European equities now before prices respond to the recovery. European equities have historically traded on average at a 10% discount to US equities, though there have been periods when it’s been at a premium (see Figure 3). Currently the discount is 14 per cent, so there is still potential for a revaluation of European equities to generate superior returns.
Figure 3: Relative valuations, Europe vs US (forward PE, MSCI indices)
Latest data 9 February 2013. Source: MSCI, Bloomberg, Factset, J.P. Morgan Asset Management.
The real opportunity, though, is below the surface. At a regional level valuations are slightly better in Europe, but at a country, sector, and company level, there is a much wider range of valuations than has been the norm historically. The spread today in valuations for stocks is twice as wide as it was in 2007. This is an environment where active management can really pay as a fund manager can identify the exceptional picks which are obscured at the index level.
Over the last 25 years, European equities have underperformed US equities by about 1 per cent per year on average (see Figure 4). Given superior earnings growth in the short-term, positive fund flows, liquidity from the Federal Reserve, and higher GDP growth, we expect US equities to still outperform this year. But investors would be wise to consider investments in European equities today. The higher dividend yields provide income now when it is difficult to find elsewhere, and it is often when sentiment is negative that the best discoveries are made.
Figure 4 : Index performance (total return, MSCI indices)
Latest data 9 February 2013. Source: MSCI, J.P. Morgan Asset Management.