Europe’s periphery could outperform core, suggests Morgan Stanley modelling

Morgan Stanley is thinking what was once unthinkable – that shares of the eurozone’s periphery could actually outperform those at its core next year.

It also predicts the European Central Bank will activate its unlimited bond-buying programme next quarter, most probably for Spain.

Despite this poor news on the macro front, for the first time in months Morgan Stanley’s modelling recently ranked Spain’s share market among Europe’s 16 most attractive, placing it fourth.

European equities analyst Ronan Carr says: “If we see a further narrowing of growth rates [between core and periphery] and further narrowing of spreads, we could see other peripheral countries move up the rankings, too.”

Carr highlighted “particularly supportive” 40% sales exposure of Spanish companies to EMs, comfortably above the 31% exposure European companies have to all EMs, and the likely triggering next quarter of ECB bond buying, “which in turn would trigger further spread narrowing, which would have a positive effect for equities in peripheral countries”.

This possibility comes against a backdrop of gradually increasing interest among allocators to think again about European shares, even if they are not yet putting their money where their mind is.

Morgan Stanley’s European equities team held a “fairly negative view” on peripheral equities until summer, given economic growth rates were below the region’s ten-year debt yields. But it moved to ‘overweight’ for the periphery, upgraded European equities from neutral to attractive citing 13% potential upside over 12 months, and formally adopted a preference for Europe over the US.

Analyst Graham Secker said, 12 months ago, some global investors located outside Europe took “zero interest in putting money here, but now the fresh money is being put into Europe even if the stock of existing money is still in the US”.

Secker added: “We have seen some rotation into Europe over the past six months. There is a lot of window shopping in Europe for the first time, even if the [window shoppers] have not done a huge amount yet. A year ago people were totally closed in their view of Europe. At least now what you start to see is people starting to look at the region, and they are asking: ‘How do I get more comfortable with Europe, and then how do I start to buy?’”

Getting comfortable with the periphery may be even harder, but Morgan Stanley makes a case for doing so.

At a macro level, current account deficits for Italy, Portugal and Spain will all narrow significantly to near zero by 2014. At the market level, peripheral markets trade close to historical lows on stable valuation metrics like price to book and price to dividend, and the Shiller P/E Ratio and Spanish, Italian and Portuguese stock valuations all rank in the bottom quartile of Europe.

“We feel authorities now have enough backstops in place so we will not get wild crashes in equity valuations again,” says Secker.

To gauge potential for equity market appreciation in Europe, Secker counsels watching for multiple expansion. He expects corporate Europe to grow earnings by 5% next year, and by 9% in 2014.

Secker says: “It is not a great environment to predict equity returns, and we will need to see some multiple expansion, and we foresee that next year.”

Morgan Stanley predicts forward 12-month P/E ratios for European companies to rise only slightly, from about 11 now to 12 during next year.

However, he acknowledged investing in Europe had been made more challenging by the many non-financial considerations that play a role.

“Trying to analyse the equity markets is increasingly difficult,” Secker says. “You grow up with fundamental models, but you also need to look at positioning and flows. The market market has become quite short term over the past few years. Fundamentals, valuation and sentiment, in this cycle, are all equally important. All our analysis is grounded in data, otherwise you are just pontificating, but it is difficult to get good data on investor positioning or flows, and where they are exactly at a point in time.

“This heightened level of uncertainty means equity valuations are low, and a lot of people are taking small sector bets.”

 

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