Uncertainty reigns in European markets

Low rate era: Commuters pass the Bank of England in the City of London. Lower policy rates are also a concern for UK banks following the Bank of England’s decision to cut rates and restart quantitative easing. – Bloomberg

THE outlook for equity markets in the second half has become more challenging.

For one, investors will need to weigh the implications of the UK’s decision to leave the European Union (EU). Second, the European Banking Authority stress tests could lead to a renewed round of cash raising from investors by banks as well as further pressure on dividends.

Then there is the increased uncertainty over the timing and pace of rate hikes by the Fed.

The common thread linking all these factors is uncertainty – which is to asset markets what a pin is to a balloon.  

The UK’s decision to leave the EU poses as many challenges for the eurozone economy as it does for the UK. For this reason, we have downgraded our outlook for eurozone equities to “cautious” from “positive”, and upgraded UK equities to “cautiously positive” from “cautious”. 

The latter upgrade reflects the benefit of a weaker pound on internationally focused large UK corporates.

Banks have been at the forefront of the uncertainty created by the Brexit vote, compounded by the results of the European Banking Authority stress test. European-listed banks have underperformed those listed in the UK year-to-date, reflecting fears over the possibility of new capital raising and lower dividends in the coming quarters.

Lower policy rates are also a concern for UK banks following the Bank of England’s decision to cut rates and restart quantitative easing (QE).

The eurozone was facing challenges that pre-date the outcome of the UK vote. Lacklustre revenue growth and an appreciating euro were already weighing on the export sector. Consensus earnings growth for the eurozone equity markets in 2016 is forecast to be a mere 4%. 

Our prior optimism towards eurozone equities was driven by the potential rebound in 2017 earnings which are forecast to grow 13%. While that forecast remains intact for now, it is almost inevitable that it will come under downward pressure in light of recent events. 

The S&P 500 has a similar pattern for consensus earnings: flat this year, rising to 14% in 2017. However, we have greater confidence in the achievability of US earnings growth, as companies there are somewhat insulated from developments in the EU, and could actually be beneficiaries of increased domestic investment diverted from the EU.  

Another factor supporting US earnings growth in 2017 is the recovery in energy sector profits – not just from a recovery in oil prices, but the dramatic decline in asset write-downs related to the prior collapse in oil prices.  

Corporate investment tends to thrive in an environment of growth and certainty, both of which are in short supply in Europe currently. 

Companies in the transportation and communications sector have already announced reviews of future investment in light of the UK vote to leave the EU. Such news will be received negatively by investors and policymakers alike. 

Slower investment will impact future profit growth and could also weigh on economic growth in the coming quarters. Already this has prompted the Bank of England to cut rates and restart QE. For the Fed, it could lead them to think twice before raising rates. 

While lower-for-longer with regard to US rates does have positive implications for high dividend yielding equities and fixed income markets, it reinforces our concern over the outlook for earnings growth and is a factor leading us to reduce our allocation to equities since the start of the year.

Where do we invest in the second half given recent events? 

We believe that the Brexit vote reinforces our key investment theme for 2016: the need to adapt. We continue to emphasise the importance of multi income strategies, which rank highest in order of preference amongst the key asset classes. Alternative strategies and fixed income, specifically developed market corporate bonds, should feature prominently in investor allocations. 

Equities, commodities and cash rank in the lower half of our asset class preferences.  

While we have reduced our allocation to equities as an asset class, within this category high dividend-yielding equities are attracting renewed interest in light of the changing expectations for rate hikes by the Fed.

Renewed interest in emerging markets

There is also renewed interest in emerging markets, buoyed by the recovery in commodity prices from prior lows and selectively high dividend yields. Reflecting both these trends, Asian REITs have rallied strongly post the Brexit vote – a performance trend we expect to continue.  

Within Asia we are positive on Indian equities. We believe India will be resilient in the face of uncertain growth trends in the developed markets. The Indian market’s greater domestic focus and the increase in credibility of monetary and fiscal policies are supportive of rising corporate profits.

While India’s high valuations relative to peers are a perennial concern amongst investors, we continue to focus on higher corporate margins and a superior return on equity as justification for the valuation premium.

Uncertainty looks set to remain a feature of asset markets in the second half. Nevertheless, we believe there remain opportunities in markets for investors who are able to adapt their investment strategies.

Clive McDonnell is head of equity strategy of Standard Chartered’s wealth management unit.