With economic improvements and the potential for an earnings recovery and margin expansion in Europe, we are guardedly constructive on EAFE markets over the coming year.
After weathering exceptional volatility for much of 2015, most international developed equity markets are reflecting optimism that economic growth rates can be sustained and that interest rates should remain low. The sharp decline in oil and commodity prices since this time last year has boosted consumer discretionary income, adding impetus to the improved economic outlook in most developed markets, which tend to be importers of raw materials. Meanwhile, the strong U.S. dollar has improved the cost position of multinational corporations that are based overseas and operate in the United States and U.S. dollar-linked markets like China.
Eurozone: Shift in Risk/Reward Balance
The most significant economic change from last year, in our view, has been the improvement in the European Union, where GDP growth appears to be on a positive trajectory. Proactive policies from the European Central Bank have reduced concerns of a potential "Grexit" and the risk of contagion to other countries. Economic policy across Europe is becoming more business-friendly, with the socialist government of France adopting more pro-growth policies, and the May 2015 elections in the U.K. returning the typically pro-business Conservative party to power with a majority.
The U.S. dollar has been strong for much of 2015, while the Swiss franc and British pound have also been resilient. These currencies seem likely to provide more modest gains in 2016 as the U.S. and U.K. move beyond easing, versus a particularly accommodative eurozone and Japan. The euro has depreciated by about 9% versus the dollar (through October 31, 2015), supporting exports just as domestic demand is improving after a multi-year slump. The resulting appetite for credit has benefited banks, and property prices have started to recover. Given an abundance of cash-rich, high-quality companies, low borrowing costs and some cheaper assets, we're also seeing increased corporate activity (such as mergers and acquisitions) that could drive stock valuations higher.
In the U.S., profit margins are at near-highs and may be eroding as the strong dollar creates headwinds for American multinationals with operations overseas. In contrast, European profits are well below historical highs, suggesting greater upside potential. In terms of valuation, many European names are trading at significant discounts to their U.S. peers, making the EU, to us, among the more interesting investment opportunities globally. As they are primed for domestic recovery, and benefiting from newly restored capital, we are increasingly finding opportunities among European banks, in addition to our longstanding optimism on European industrial and technology firms.
European Margins Show Potential over U.S. Counterparts
EBITDA Profit Margins: U.S. vs. Europe (%)
Source: Datastream, Bernstein analysis. Data through September 30, 2015.
Japan: Weak Yen Benefits Exporters
In Japan, economic data has been weak. Investors appear to be fixated on the Bank of Japan, hoping that another round of quantitative easing will boost growth, lift inflation and weaken the Japanese yen. We prefer a focus on companies, working to identify firms with attractive returns, sustainable growth and disciplined use of cash flow. We consider exporters that have met the challenges of global competition and are beneficiaries of a weaker yen particularly interesting.
The Japanese Economy Has Been Stumbling
Change in Real GDP (%)
Source: Bloomberg. Quarter-over-quarter, seasonally adjusted annual rate.
Quality and Value in 2016
Low prices do not necessarily mean better value, and given fundamentals, we remain leery of the commodity sector, where many companies are not covering their cost of capital. We see the greatest potential upside in financials, especially in Europe, as well as select technology and industrial names. Consumer staples and health care contain many high quality businesses, but current valuations more than reflect their quality.
Certainly risks remain-including the possibility that China could stumble during its transition to a consumer-driven economy, increasing geopolitical discord in Russia and the Middle East, and the possibility of added stress as the Fed tightens-but generally low valuations, especially in Europe, help balance risk. Unlike recent markets, which were significantly characterized by momentum factors, we anticipate an environment where investors seek opportunity among underperformers. In our view, a value- and quality-focused market provides an excellent platform for fundamentally oriented managers over the coming 12 months.
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