Euro Area

U.S. companies have historically traded at a premium to their European counterparts because of better underlying 'financials'. To address this issue, we developed the "Fundamental Approach" to determine the relative value of European equities in comparison to the U.S. Our analysis involved regressing the difference in the valuation metrics between the two markets on differences in financial variables, including RoE, operating margins, trailing EPS, forward EPS, sales-per-share, interest coverage, two measures of leverage and cash flow growth. While not as successful as the mechanical approach, the regressions confirmed the conclusion of the mechanical approach. The historical "batting average" of the fundamental valuation indicators are also good. Taken as a whole, our analysis suggests that Eurozone stocks are on the cheap side of fair value versus the U.S. at the moment, but not by enough to justify overweighing the Eurozone based on value alone. One also needs the expectation that European earnings growth will be better than in the U.S. over the next 1-2 years. Indeed, we are more bullish on Eurozone EPS growth than for the U.S. due to ongoing margin pressure in the latter market. For additional details please see Monday's Special Report.

European stocks have lagged the U.S. by a wide margin in the post-Lehman era. The relative EMU/U.S. total return index is close to its lowest level since the late 1970s in local currency terms. It is tempting to take a contrary position, especially since European stocks appear cheap relative to the U.S. on the surface. Nonetheless, European stocks have traditionally traded at a discount, in part because of persistently lower profitability. A Special Report - first published in the Bank Credit Analyst last month - takes a top-down approach to determine whether Eurozone stocks are cheap versus the U.S. after adjusting for persistent differences in underlying profit fundamentals. The report focused on the non-financial sector, and re-weighted the Eurozone equity index using U.S. weights in order to avoid the problem that differing sector weights could bias measures of relative value for the overall market. The report employed both a mechanical approach and a fundamental approach. Seven valuation measures were used, Price/Sales, Price/Forward Earnings, Price/Cash Flow, Price/Book, EV/EBITDA, Price/Trailing Earnings and Shiller P/E. The mechanical approach adjusted the valuation measures by subtracting the 5-year moving average from both markets. We then divided the Valuation Gap (VG) between the U.S. and Eurozone markets by the 5-year moving standard deviation of the VG. In this way, we adjusted for the persistent, but time-varying, gap between the two markets. The result is an indicator that moves roughly between +/- 2 standard deviations. Valuation is not a timing tool, but our analysis of the historical "batting average" shows that all of these valuation metrics except the trailing P/E provide value added as an investment tool. Historically, there was a high probability of a significant excess return to positioning in a contrary fashion between the two markets when relative valuation reached 1 and, especially, 2 standard deviations away from the mean. Currently, all of the mechanical valuation indicators suggest that Eurozone stocks are on the cheap side of fair value relative to the U.S., except for the trailing P/E. However, only two are more than 1 standard deviation away from the mean. We then approached valuation from a fundamental perspective (see next Insight).

Special Report

Eurozone equities have delivered one of the worst stretches of underperformance in more than 25 years. Are European equities a 'buy' versus the U.S., or are they "cheap for a reason"?

Over the past 12 months, the yen surged, powered by global deflationary fears. Japanese monetary conditions massively tightened, causing additional yen strength, creating a vicious circle. Policymakers will respond, but markets are likely to be disappointed. Nonetheless, global factors could temporarily move against the yen. Buy NOK/JPY and AUD/JPY. The BoE will move next month. The BoC will stand pat for the foreseeable future.

The perception that central banks have turned even more dovish has pushed down global bond yields, while also giving stocks a lift. Looking out, bond yields are likely to edge higher as investors begin to focus more on the outcome of easing measures: Higher inflation. As long as yields rise gingerly and in the context of firming economic growth, global equities will remain reasonably well supported. Equity investors should favor the euro area, Japan, and China.

Given that the seemingly unthinkable can actually happen, we reassess how financial markets price uncertainty, and whether the current pricing is correct.

Special Report

Signs that the median voter is moving to the left are everywhere. Markets will cheer the move as it means more government spending. In the long term, it depends if policymakers stop at fiscal stimulus. In this <i>Monthly Report</i>, BCA's <i>Geopolitical Strategy</i> reviews prospects for "Bremorse," latest in the U.S. election, Italian political crisis, tensions in South China Sea, and the long-term future of Europe.

Signs that the median voter is moving to the left are everywhere. Markets will cheer the move as it means more government spending. In the long term, it depends if policymakers stop at fiscal stimulus. In this <i>Monthly Report</i>, BCA's <i>Geopolitical Strategy</i> reviews prospects for "Bremorse," latest in the U.S. election, Italian political crisis, tensions in South China Sea, and the long-term future of Europe.

Please see attached our <i>Third Quarter Strategy Outlook<i/> which discusses the major investment themes and views we see playing out for the rest of the year.

Brexit is putting our bearish short-term dollar view in question as global policy uncertainty has surged. Yet, investors are displaying elevated signs of risk aversion but the global economy still looks fine. This dissonance is likely to end with investors increasing risk taking, a bearish development for the counter-cyclical dollar. Favor commodity currencies over European ones.