‘Undervalued’ European Equities Look Better Bet Than US

Pictet Asset Management predicts that European stock markets will outperform US equities over the next five years

Karen Kwok 20 June, 2017 | 3:27PM
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Concerns about an overheated US stock market have led Pictet Asset Management to favour European equities instead. The fund management group says that it expects Europe equities to outperform US stocks over the next five years.

Luca Paolini, chief strategist at Pictet Asset Management, says the group is diversifying away from US stocks because of high valuations. After an eight-year US stock market rally, Paolini pointed out that the US market is the most expensive equity market in the world right now.  As if to illustrate this point, the S&P 500 closed at an all-time high of 2453.46 yesterday – boosted by a rebound in shares of technology companies.

Paolini said: “The US market looks the most vulnerable across the global market. The valuation of US stocks is high while US economic growth is low; and investors are very relaxed about it. This is never a good sign.” This is why Pictet expects this market to be ‘challenging’ in the years ahead.

Pictet calculate ‘valuation percentiles’ to give some indication of how expensive an asset class is. The closer the figure is to zero the more expensive it is; conversely the closer it is to 100 the cheaper the asset class.

Five years ago US equities’ valuation percentiles were at 82 - now they are at 24, according to Pictet’s calculations. In contrast, European equity valuations are at 56 – so are a much cheaper asset class relative to US shares.

European Stocks Have a More Solid Background than US

There are three factors driving equities’ asset values over the long term, according to Paolini: economic growth, monetary policy and valuation.

In terms of economic growth, Pictet forecasts that US growth will average 1.8% over the next five years. As Paolini points out: “Growth is driven by the working population, and the number of people available to work. The working population in the US is shrinking and if you look at productivity it is close to an all-time low, even with the help of technological innovation.”

But while Pictet expects growth to remain low in the US, compared to other parts of the globe, the asset manager also predict similar, or lower growth rates, Japan, the UK and the Euro. So why favour Europe over the US?

Paolini says Europe is a better place to be in terms of monetary policy. “Liquidity conditions in Europe should be better than in the US, as the European central bank will not raise rate for the next year or two,” he explained. In contrast the US Federal Bank has alright started raising rates.

Paolini also point out that Europe’s business cycle is currently well behind the US, so there is a more solid background to invest in European equities at present.

He explains: “The recession in Europe was in 2013, while the US was in 2009. Europe is roughly three to five years behind the US in terms of valuations, business cycle and inflation.

“It does not mean that Europe will do what the US did in the past five years, but there is a much more solid background for Europe to perform better than the US. Even if investors became very bearish against Europe, I can tell you US companies will buy European companies and the gap will be closed by M&A.” He described Europe as having some “fantastic companies”.

The Biggest Risk in the Next 6 Months: Market Overreaction

The biggest risk that the market is facing in the next six months is market overreaction, said Paolini.

“There is a huge gap now between confidence and economic data. I think at some point investors are going to start asking questions about whether Trump will deliver, and whether US interest rates will go on to 2% this year.” There is the potential for disappointment on both he said – and so potentially more disappointing growth figures.

“This combination of a very high valuations in the US stock market, the suggestion of a US economic slowdown and tightening financial conditions, makes the US equity market a very dangerous place,” he explained.

Paolini believes the Federal Reserve knows they are behind the curve, as there is no reason why rates in the US should be below inflation - given current economic conditions.

“They know they are behind the curve and they want to close this gap. Maybe they are closing it too fast when the economy is slowing down, that’s a potential risk,” said Paolini.

Without Emerging Markets It is Difficult to Deliver ‘Real’ Returns

Despite his more positive outlook on Europe, Paolini said that investors who can embrace risk should look towards emerging markets.

“If you want to returns of up to 5% in the next five years, you cannot avoid moving money out of the US, Europe and Japan. A portfolio that only contains US, European and Japanese bonds and stocks will struggle to generate a real return of above 1% per year in US dollar terms. A 50/50 equities bond portfolio is likely to give you zero return after inflation; so that’s why you need to have emerging markets, and alternatives in your portfolio. You need to be bolder,” said Paolini. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Karen Kwok

Karen Kwok  is a Reporter for Morningstar.co.uk

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