European
Stocks Aren't as Cheap as They Look
The apparent cheapness of European and U.K. equities has nothing
to do with geography and everything to do with what companies are in the
relevant markets.
By
December 9, 2020, 2:00
PM GMT+8
When the bubble bursts…
Photographer: JOHANNES EISELE/AFP
Richard Cookson
was head of research and fund manager at Rubicon Fund Management. He was
previously chief investment officer at Citi Private Bank and head of asset-allocation
research at HSBC.
Most bank strategists think European stocks are really cheap. The
snag is that this view is at once trivially true and very misleading. It is
true because European and U.K. stock markets do indeed look cheaper than their
U.S. counterparts. But this has nothing to do with geography and everything to
do with what companies are in the relevant markets.
Look at
the sectoral differences in the MSCI indices for the U.S., Europe and the U.K.,
which don’t vary that much from the more popular broad indices. Technology
companies account for about 28% of U.S. large caps. In Europe and the U.K., the
numbers are 7% and 1.5%, respectively. It is tech firms that account for the
most gushing of nosebleed valuations.
At the
other end of the scale, energy, the dog of the past umpteen years with
valuations to match, accounts for slightly less than 4% of the European stock
market and 8% of the U.K.’s. In the U.S. it’s just under 2%. If you were to
apply U.S. sectoral weightings to Europe and the U.K., you’d pretty much end up
with the same valuations.
So what
strategists are really saying is that there will be a rotation out of tech
into, say, financials or energy. Although I have sympathy with that suggestion
and I would be a seller of tech stocks over the next few weeks, there will
probably be a better time to buy their cheaper counterparts.
Strategists
are assuming — because they always do — a buoyant appetite for risk. The
consensus of their views has never forecast falling stock markets in the
developed world. This time their assumptions are underpinned by central banks,
especially the U.S. Federal Reserve, keeping monetary policy super loose at the
same time as the global economy picks up sharply.
Thus does the consensus for next year see European and emerging
equities doing splendidly. It also sees steeper yield curves, the dollar
falling, high-yield bonds outperforming and so on and so forth. That’s par for
the course for predictions of the year to come. They may, of course, be
correct.
Three
things make me especially nervous, though. The first is that the consensus is,
as it were, even more consensual right now: Seemingly everyone has the same
view of the world. My second concern is that trades favored by the
consensus have a nasty habit of getting a good kicking in the first few months
of the year.
The third
worry is more fundamental. Although central banks have said they’ll keep
monetary policy very loose, I doubt that markets will continue to price in no
rate rises at all in the U.S. until 2023, or before 2024 in the euro zone or
the UK. Longer-dated bond markets look horribly extended.
Let’s
assume that inflation picks up at the beginning of next year. Central banks
will shrug off overall inflation prints of 2% or thereabouts and so will
markets. What happens if we get much higher prints? The prices of all manner of
things, commodities not least, collapsed in the spring of this year. This means
that year-over-year comparisons are likely to look pretty astonishing in the
spring of next year. Again, central banks will try to ignore movements that are
due to such base effects. It would be astonishing if bond markets did the same.
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Central
banks and investors alike will find it even harder to ignore rising core
inflation, which strips out food and energy prices (although there is much less
difference between overall and core inflation than everyone assumes). If I’m
right that the Covid pandemic has reduced the supply-side potential of
developed-world economies, then a pickup in demand growth is likely to lead to
higher prices.
Core
year-over-year consumer inflation prints in the U.S. of, say, 4%, which doesn’t
seem unlikely, will hugely test the Fed’s and other central banks’ resolve.
Quite rightly, investors will calculate that central banks cannot be so dovish
in the face of new information and bring forward the date at which central
banks tighten.
Which is
where we get back to the question of European stocks and other, apparently
cheap, assets. The last time there was such a mania for tech stocks was in the
late 1990s. On proper, mean-reverting, valuation metrics, using more than 100
years of data, the overall U.S. market is again in the 96th percentile of
valuations.
That
previous bubble eventually popped thanks to a few rate rises from the Fed.
Initially, at least, everything else went pop, too, before a powerful sector
rotation set in. It would almost certainly take much less than before to burst
this latest bubble, so key have central banks been to inflating it in the first
place.
European
stocks might do less badly than the U.S. when the tech bubble pops, but history
is not your friend when it comes to absolute returns.
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