Deutsche Bank Research analysts Binky Chadha, Keith Parker, John Tierney and Parag Thatte evaluate asset allocation between Europe and the U.S. in the light of the recent re-rating of European equities. Based on a host of factors, they conclude that Europe is more expensive than it looks.
Post July outperformance (+8%) of European equities versus U.S.
The analysts question whether the recent re-rating of European stocks is justified by forward earnings growth. Relative valuation for Europe has swung between the bottom up consensus of earnings growth and the upper end of the band. The re-rating since mid-July has taken relative valuation from slightly below average to near the top of the band. “At a 6.5% valuation premium it is pricing in somewhat more than the bottoms-up consensus which sees 2014 European earnings growing 4.5% faster than in the US.”
Since 2010 European equities have underperformed the U.S. by 45%
The analysts are of the view that this sustained underperformance was entirely due to poorer earnings relative to the U.S., and this might not have changed dramatically in the short term.
In fact there is a lot of history here – European multiples have been lower than the U.S. since early 2000s
European multiples were lower than the U.S. even before the great crisis and the discount has averaged around 2.5 multiple points. Contrary to an opinion that the lower multiples could be a value opportunity, the analysts suggest the discount was really an offspring of rising global market correlations that made an allowance for the higher price and earning volatility of European stocks. The discounting is also apparent in a sector-wise comparison of stocks – seven out of ten sectors in Europe have usually traded at a discount to their U.S. counterparts.
No slackening in European earnings downgrades…
The analysts note that downgrades continue at only a slightly slower pace after Q2, yet the net revision ratio at -41% shows the declining earnings quality. In contrast, earnings estimates in the U.S. are rather stable.
Slower European GDP growth neutralizes its operating leverage advantage
The analysts estimate that operating leverage of European earnings to GDP growth is 1.7 times that of U.S. earnings. But this may not play out because the U.S. has grown much faster than Europe and is likely to continue to do so.
DB projects 2014 nominal GDP growth of 5% in the U.S. and only 3% in Europe. Earnings growth rates are expected to more or less similar in the two regions.
“We stay neutral Europe and overweight U.S. equities given Europe’s already sizeable outperformance and relative re-rating to the top of its band even though earnings continue to be downgraded. Additionally, resolution of the US debt ceiling should see the US outperform. We remain neutral Europe until two of the following three parameters turn in Europe’s favor: the economic growth gap narrows, downgrades stop, or relative multiples get cheap.”