Stick with Europe and Japan

With Wall Street looking overhyped and overpriced, which regions in the developed world still look promising? Step forward continental Europe, which last hit a record high in 2015 and has some catching up to do. The single currency area’s economy “has come back from the brink”, says David Smith in The Sunday Times. Growth is at its strongest for six years, according to the latest business surveys. Unemployment has fallen to 9.6%, a seven-and-a-half-year low, compared with a peak of 12.1% in 2013. Overall inflation has risen to 2%, “a long way from deflation”, so the danger of a Japan-style slump is receding.

Another reason to like European equities is the potentially sharp jump in earnings stemming from high operational gearing. European firms have high fixed costs, especially for labour. That makes profits very sensitive to a change in sales. Assuming sales track GDP growth, notes BlackRock’s Richard Turnbull in the Financial Times, then a rise in sales should disproportionately benefit companies with high fixed costs.

US firms, where costs are lower and more variable, will not get the same fillip. European stocks are also more cyclical and exposed to the global economy than their US peers. So firmer global growth, in addition to a weakening currency, should give European earnings a boost. A global survey tracking both manufacturing and services is close to a three-year high, notes Capital Economics. Barclays is pencilling in Europe ex-UK profit growth of 12% this year. Political risk looms over the eurozone, but most of it appears to be in the price: “price-to-book measures, for one, are near all-time lows”, says Turnbull.

As far as valuations are concerned, Japan also remains appealing. Forty per cent of its stocks trade below book value, as MoneyWeek contributor Tim Price points out in a recent Price Value Partners note. The arguments that gearing and a weak currency should buoy profits apply to Japanese firms as well, but the most striking aspect of the market is the extent to which the central bank and the government are providing shares with tailwinds.

“As well as pursuing the biggest and longest-running quantitative-easing programme anywhere in the world, the Bank of Japan is directly buying company shares,” says Jonathan Davis in The Spectator. The government pension fund and firms themselves are also buying up stocks, while a corporate governance revolution has ensured that dividends are on the rise across the board. Investors who think of Japan as a low-yielding market will be surprised to know that the yield on Japanese stocks has eclipsed its US counterpart. The upshot? “The real risk in Japan is not owning enough of it,” says Price.