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European Equities Compelling Amid Cheap Valuation, Underperformance

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European equities received a surprise gift from the ECB in the form of an interest rate cut last week. This was some more icing on the cake, given that European stocks were already chalking up their fifth straight week of gains. However, Standard & Poor promptly rained on their parade by downgrading France’s credit rating from AA to AA+. As a result, stocks closed lower Friday.

Nevertheless, market participants appeared to be happy with the gains clocked by European stocks this year; Pierre Mouton, a portfolio manager at a Swiss firm was quoted by Bloomberg as saying, “The ECB rate cut is good news, not only because of easier money but also because it should push the euro lower. I’m very happy with the performance of European equities so far this year and we still prefer it for valuation reasons.”

U.S. investors appear to share this view – after all they pumped in over $81B into European equities by end-August this year, the heaviest buying seen since 1992/93.

Yet, there are murmurs and worries about the real economic health of the region, given that the ECB had to resort to a rate cut. Are stocks getting ahead of themselves?

A Barclays Research report authored by strategists Joao Toniato and Dennis Jose analyzed the October performance of European stocks and appears rather sanguine with current valuations.

“Aided by a turnaround in European profitability, a pickup in the European economy, attractive valuations and a gradual reduction in political tail risks, we find the European equity market a very compelling investment proposition,” say the analysts.

Earnings growth

They expect strong earnings growth in the region of up to 4% in 2013 and 12% in 2014 for the STOXX 600 index, a sea change compared to the rather pathetic negative growth witnessed in 2012, and the 0% growth expected by the consensus for 2013. “Our forecasts are driven by our view that European profit margins should be at a cyclical trough…European profit margins are low because we have had a severe contraction in deficits when investment was poor. More importantly, going forward, we find that every factor within Kalecki’s framework should improve for European equities, helping profitability recover,” says the Barclays report.

A cyclical European recovery

The Barclays PLC (NYSE:BCS) (LON:BARC) analysts are of the view that “the point of maximum economic pain in Europe could be behind us, and that economic data should surprise to the upside going forward,” and therefore continue to be bullish on Europe stocks and especially cyclical plays.

Value stocks will outperform during cyclical recovery

The improving macroeconomic environment makes value stocks attractive investments, say the analysts, regardless of the periodical political uncertainty that assails the region.

A look at the performance of MSCI Europe:V index versus the MSCI Europe:G index (yellow highlighted) in the table below shows that the latter is clearly outperforming over the last 12 months.

This is also confirmed by the sector-wise performance seen in the chart below. Cyclical sectors such as autos, financial services and media have done rather well over the past 12 months.

Tail risks fading?

The analysts also point to the fact that tail risks in the region appear to be abating with solid falls seen in government bond yields, particularly at the periphery of the zone (Italy -31bps, Spain -28bps, Greece -137bps).


Barclays bullish on European equities

Given a better outlook on the macroeconomic situation, improving earnings, a cyclical recovery and renewed investor interest, Barclays PLC (NYSE:BCS) (LON:BARC) is understandably bullish on European equities.

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