Stock markets have bounced up and down recently, as fears of a double-dip recession have alternated with bouts of confidence that the recovery will continue. Even so, UK-based economist and commentator Andrew Smithers noted in a recent report, economic forecasts from the IMF and OECD, among others, “while demonstrably fallible”, assume that economic recovery will continue.
Indeed, as Lex recently noted, the OECD’s latest economic outlook “should be taken with a truckload of salt”.
Nevertheless, says Smithers, on the basis of such broadly upbeat forecasts, “there is clearly plenty of support for optimism”. However – and there’s a big ‘however’ – the general assumption that continued recovery will be accompanied by profit growth seems “fundamentally unsound” in Smithers’ view, leading him to caution that corporate profits seem almost certain to fall as budget deficits are cut back.
And that, combined with the relative weakness of the euro, in his view, makes a compelling case for going overweight in German and French non-financial stocks. Here’s his reasoning (our emphasis):
It seems likely that the US stock market will fall as profits disappoint and, as major stock markets are highly correlated, this will be a common phenomenon.
Profit prospects are, however, better in France, Germany and Japan than in the UK and US. These markets seem also to be relatively cheap.
It also appears that investors are more liquid in Europe than in the US, both absolutely and compared with their average ratios.
Europe’s interconnected problems are due to the probability (i) that Greece will default, though not immediately, (ii) that other peripheral economies in the eurozone are shaky and (iii) that eurozone banks need to raise even more new equity than those in the UK and US.
These problems have, however, produced the substantial benefit of weakening the euro. There is therefore a strong case for overweighting French and German non-financials relative to their US counterparts. Equity markets are, perversely enough, more closely correlated in domestic currency terms than in dollars, so investors should benefit if the euro rebounds.
If the euro does not recover, however, it will reinforce the case for overweighting French and German non-financials because their profit outlook is less bad than those of similar US companies.
Stock markets tend to be more highly correlated in terms of their changes in local currencies than in a common currency, for example, dollars, notes Smithers, noting that this historic pattern has also been seen since the start of 2009.
Since the beginning of 2009, the returns from the stock markets of France, Germany, the UK and the US have been very similar in local currencies. It is therefore “reasonable”, he argued, to expect that if the euro strengthens against the dollar, investors in the French and German equity markets will benefit in the relatively short-term.
However, this relates to non-financials only, he stresses: “The outlook for financials is a political rather than economic issue… On any rational analysis, banks need to increase their equity ratios by multiples of their current level”.
But it’s unlikely, he adds, that such a radical change will be introduced in the short run:
The short run outlook for financials is thus dependent on the extent to which the need for additional equity, which is almost universally accepted by economists, is successfully resisted by bankers using their massive political clout.
The case for French and German shares in preference to US ones, according to Smithers, is reinforced by estimates of fund managers’ liquidity. He cites a recent FT article ["Cash is again the currency of risk-averse investment"] which notes that UK fund managers’ liquidity ratio was recently 8.7 per cent compared with around 7 per cent over the past two years, while the European (presumably ex-UK) ratio was 6.8 per cent compared with 6 per cent.
The US liquidity ratio, meanwhile, is 2 per cent compared with 3 per cent (the average ratios are rough estimates drawn from the published charts).
In other words, there’s a lot more money sitting on the sidelines in Europe and awaiting investment.
Related links:
Cash is king - Lex
America: Optimism on hold – FT