Europe over the US, cyclicals over defensives
JP Morgan urges investors to go against the widespread consensus view
With Europe (both the continent and the UK) appearing to be the most unloved region of late, the broker has reiterated its preference for European equities after upgrading Europe versus the US last September.
In addition to the widespread view that credit is bound to lead stocks and that deflation is the key macro theme, investors also believe that the macro situation will get worse before it gets better and consequently equities will perform poorly in the first half of 2009 with potential recovery only in the second half or later, that an equity rally cannot take place with the participation of financials, that remaining overweight on defensives is the only way to be, and that regionally one should also be overweight on the US relative to Europe.
JP Morgan, however, believes the opposite. The broker believes that the equity trajectory could surprise with stocks performing better near term but potentially rolling over again in the second half, that divergence in performance of financials and the rest of the market can continue as financials will be used as a vehicle to re-inflate the economy and will therefore suffer extreme dilution in the process, that one should currently be overweight cyclicals, and that Europe offers far better investment opportunities than the US.
Far from ignoring the US slowdown, European stocks actually underperformed US stocks on the way down as they faced additional headwinds in terms of appreciating currency as well as the lack of ECB support, JP Morgan said in this morning’s note to clients.
Analysts at the firm underlined that they are not claiming that European stocks can directionally decouple from US stocks, as the correlation between the two equity markets is very high, but simply that the risk-reward ratio is much better in Europe.
“Irrespective of whether US stocks are up or down this year, European ones will be the outperformers, in our view,” the analysts wrote.
There is a widespread belief that European corporates are more financially distressed than their US counterparts, but JP Morgan’s research suggests balance sheet leverage ratios in the two regions are roughly in line.
“Financials’ leverage is a worry, as European banks show greater gearing than their US peers…However, they have been proactive in capital-raising, and on average the European consumer is not as stretched as the US consumer,” JP Morgan said.
The broker found that on most measures European equities are trading at a significant discount to their US counterparts: Europe offers almost double the dividend yield of the US, at 5.6% versus 3.1% respectively—the highest ever yield spread, according to the broker’s calculations.
Of course dividends are being significantly cut in both regions, but JP Morgan’s analysts believe the relative gap will remain large. They added that this relative cheapness is broad-based as most sectors in Europe are trading at a substantial discount to their US counterparts. Among them, European Materials offer the greatest discount, the analysts believe.
Broadly, JP Morgan sees stocks as being in ‘capitulation’ mode and advises buying on dips.
The analysts have selected a number of top picks for each sector. Looking at the UK-listed stocks among them, BG Group is their preferred Energy sector pick, InterContinental Hotels and Marks & Spencer feature among the Discretionaries, British American Tobacco and Britvic are highlighted from Staples, and International Power from the Utilities. Unsurprisingly, none of the UK’s banks or insurers is listed amongst JP Morgan’s preferred Financials plays.
