Full valuations and some downside potential

Over the last 6 months, Morgan Stanley analysts think that European equities may have negative returns as the combined market timing indicator has moved to positive levels (a sell signal). The combined market timing indicator is at +0.1 and this level can be associated with a decline of 0.9 percent over the next 6 months according to Morgan Stanley back tests. The fundamentals indicator is also getting close to sell levels at +0.3. Such indicators take into account business surveys, return on equity, bond yields, credit spreads, money supply, and momentum (a proxy for sentiment).

Morgan stanley

Morgan stanley

Trailing price to earnings and median price to earnings are close to long term averages or slightly above, suggesting that returns can be muted. The next 12 month price to earnings ratio is also close to its long term average but slightly below.

MSCI Europe

MSCI Europe

MSCI Europe

Morgan Stanley analysts believe that future growth and better inflation expectations may be already accounted for in European equity valuations. Citi analysts have revised up their GDP forecasts for 2013 implying a 0.5 percent growth in GDP for the Euro Zone for the year. The revision is supported by an uptick in exports to countries outside the Euro Zone and less severe fiscal tightening relative to Citi’s expectations. Also, falling inflation may be driving real incomes and domestic consumption. Headwinds to stronger growth, in Citi’s view, include high debt levels at the public and private levels and persistently high unemployment across the Eurozone. In the UK, Citi analysts foresee faster economic growth at 1.1 percent for 2013 and 2.1 percent for 2014. The pace is faster relative to the Eurozone as a whole as housing, consumer spending, and exports are growth drivers. Also, monetary and fiscal policy will likely remain accommodative unless inflation spikes or signs of financial instability emerge.

Federal Reserve pulling back some bond buying from the markets

Over recent years, accommodative monetary policy has been associated with higher equity multiples and prices. The prospect of the U.S. Federal Reserve pulling back some bond buying from the markets creates potential downside volatility for equities, in Morgan Stanley’s view. Furthermore, the correlations between equity prices and bond yields had turned negative in recent months, which suggest that higher bond yields could be followed by a drop in stock prices.

equity correlation to bond yield

Investment Opportunities: Morgan Stanley

Countries that have more attractive valuations and upside potential, according to Morgan Stanley analysts, include the U.K., Norway, Switzerland, Greece and Austria. Market participants are underweighted relative to the MSCI Europe benchmark in these countries. Portugal and Germany are also cheaply valued but market participants are either neutral or overweight in these countries versus the benchmark. If investors are looking for income within European equities, Finland, Italy, Norway, Portugal, Spain, Sweden and the U.K. offer dividend yields above the average of 3.6 percent consensus forecast for MSCI Europe for 2013.