Last updated: 10:38 / Monday, 5 January 2015
MFS Research

Are Valuation Divergences in Equities Justified?

Are Valuation Divergences in Equities Justified?

As always, the question for equity investors is whether the risk/reward trade off is compelling enough. 

Beginning 2015, investors have been ascribing an ever wider price-to- earnings multiple for developed markets relative to emerging markets. This divergence made sense as the United States, in particular, has delivered earnings growth and improving returns on equity (ROE), whereas emerging markets have not, explains a recent research by MFS.

Developed market valuations

Only in the US equity market has the forward P/E been trending higher, said the firm, reinforcing the importance of continued US corporate earnings and sales growth. Apprehensive that US margins might be stretched, investors are worried whether the momentum can continue. Yet with wages rising slower than revenues, energy prices falling and interest rates remaining low, we are not as concerned. Nevertheless the prospect of Fed rate hikes in 2015 has the potential to cap further upside in P/E multiple expansion, suggest the team of MFS. Historically, market indices have tended to peak no sooner than four months before the first rate increase and edge lower after a series of rate hikes, so there is precedent for caution.

Presuming forecast earnings can be delivered, many other DM regions look relatively inexpensive on valuation. In both Japan and Europe, the report card for 2014 will likely show that unprecedented policy support is simply not transmitting into growth in the broader economy. While Prime Minister Abe’s “three arrows” and ECB President Draghi’s pledge to do “whatever it takes” were initially well received by markets and generally regarded as defining moments for policy, both economies showed minimal evidence of cooperation with their central bankers.

Japan takes action again

In what was arguably one of November’s biggest macro developments, Japan’s policymakers surprised the markets by announcing a fresh round of stimulus. A few weeks later, data confirmed that the economy slipped into recession in the second quarter, prompting Abe to call an early election to reaffirm his support. Such action could be positive for the Japanese equity market in the short term but may be unsustainable without real structural change to drive durable ROE improvements. While corporate profitability may pick up next year thanks to the weakening yen, our long-term time horizon makes us cautious.

Similarly, the reform and growth picture in Europe is not much brighter, which is why the ECB may eventually be forced to resort to aggressive quantitative easing along the lines of the Fed and Bank of Japan programs. Over the course of next year, however, we do expect financial conditions to ease, with less fiscal drag and a weaker euro also helping to provide some support for eurozone earnings.

China and emerging markets

Not to be outdone on stimulus, the PBOC also announced an unexpected policy easing, which was widely interpreted to provide some near-term stability and limit the danger of a hard landing for China’s economy. This surprise move was yet another example of a central bank’s willingness to do more to minimize downside risk.

Even though MFS recognizes the flaws of considering EM countries homogenous, they generally face a subdued growth outlook. Just a few years ago the bullish EM story seemed so compelling, but now the common denominator across these economies is the difficulty in transitioning from fixed-asset investment to consumption-led growth. Sectors exposed to the theme of a rising middle class — for example, consumer staples and health care — are quite expensive relative to their DM counterparts, creating a dilemma for investors in EM equities, remarks MFS.

Focus on fundamentals

Equity markets are clearly at an inflection point. Outside the US market, which has regained its footing, other regions are still suffering from low consumer confidence, limited capital spending and deflationary pressures, leading to negative earnings revisions and equity market underperformance. Japan has been the only exception, primarily because of the weak yen.

Environments like these are often characterized by far greater stock price volatility than the changes in underlying earnings and dividends warrant. Without a doubt, the global economy remains weak — but it is not deteriorating. With central bankers still willing to provide support until job creation broadens and growth becomes self-sustaining, we believe the case for equities remains reasonable even though valuation support is weaker. We repeat our mantra that there are still opportunities among higher-quality companies with strong balance sheets and earnings visibility, concludes MFS.