The underperformance of European stocks relative to their U.S. counterparts may be ending, as investors speculate the European Central Bank will win the backing of government leaders on a plan to ease the euro area’s debt crisis.
The Euro Stoxx 50 Index -- a benchmark of blue-chip shares -- has risen 8.1 percent since July 25, the day before ECB President Mario Draghi pledged that policy makers are “ready to do whatever it takes to preserve the euro.” By comparison, the Standard & Poor’s 500 Index has risen 2.8 percent during the same period. The recent outperformance comes after the European index lagged behind the S&P 500 by almost 80 percent between March 9, 2009, when the U.S. index hit a 13-year low, and June 18, 2012.
As “most of the bad news” already may be built into market prices, Pioneer Investment Management Inc., which oversees about $185 billion in assets, “cautiously moved to a risk-on” position in European equities about a month ago, while remaining underweight U.S. stocks, said Monica Defend, head of global asset-allocation research in Milan. While this “appears to be a bold move” in the current market, “we should not underestimate the commitment of leading central banks” to provide support to the financial system, she said.
The rationale for this strategy is twofold: attractive valuations for European stocks and “most importantly, we were strongly convinced that the ECB would intervene” to solve the region’s debt crisis, Defend said.
She has “some expectations” for the ECB’s governing council meeting, scheduled for today in Frankfurt. It remains to be seen what type of action the central bank will take, though it has some “unconventional measures” at its disposal, Defend said.
Draghi’s speech has raised speculation that the central bank will embark on large-scale government-bond purchases to reduce borrowing costs in Spain and Italy. The ECB flooded markets with more than 1 trillion euros ($1.22 trillion) of cheap three-year loans in December and February. Other options include cutting interest rates further, purchasing bank and corporate bonds to ease financing conditions and offering banks another batch of long-term loans.
Until further action is announced, “Draghi’s comments potentially signal a significant change in the ECB’s reaction function,” Stephane Deo and Ramin Nakisa, UBS AG strategists based in London, wrote in a July 29 report. Given the prospect of a “structural shift” in monetary policy, they upgraded their recommended allocation of Europe’s equities from “underweight” to “neutral.”
European underperformance started to end by mid-June, showing that investor sentiment was improving even before Draghi’s comments, said Jim Stellakis, founder and director of research at New York-based research company Technical Alpha Inc.
That’s in part because European stocks are at “a cheap and unloved starting point,” said Graham Secker, head of European equity strategy in London at Morgan Stanley. The Euro Stoxx 50 is trading at about 10.6 times its price-to-earnings ratio, compared with 13 times for the S&P 500, according to data provided by Defend. The historical average multiple is 15 for European stocks and 15.6 for U.S. stocks, she said.
Since Europe’s market stopped lagging behind the U.S. in June, followed by the strong price reaction to Draghi’s July 26 speech, now “betting against Europe is not attractive in the short-term,” Stellakis said. If the Euro Stoxx 50 can outpace the S&P 500 by about another 2 percent to 3 percent from current levels, a nearly two-year trend of investors underweighting European equities would be broken, he said.
A clear pattern of European outperformance could take months to develop amid a lot of market volatility, “but looking back, this could prove to be an important shift in investor sentiment,” Stellakis said.
Given how much the stocks have underperformed since 2009, even a “modest” change in prospects for “more aggressive” ECB policy action can cause European shares to rally more than U.S. counterparts, Secker said. “I certainly wouldn’t want to be underweight Europe versus the U.S. right now.”
Even so, underlying risks in the euro area may support such a recommendation on equities in Spain, Italy, Greece and Portugal, said Tom Elliott, a global strategist at JPMorgan Asset Management in London.
While he’s neutral on “core Europe,” including Germany and the Netherlands, the region’s equities will remain volatile until there’s “wholehearted conviction” from Germany and France to support politically an increase in fiscal support by the ECB, he said.
There’s now a “risk of disappointment” if there’s no substantive follow-through by the central bank, Elliott said. What’s more, the ECB is perceived to be reacting to the region’s fiscal crisis, rather than taking a proactive approach, which engenders little confidence among investors, he said.
The S&P 500 fell 0.3 percent to 1,375.32 yesterday, reversing earlier gains, after Federal Reserve Chairman Ben S. Bernanke held off on stepping up record stimulus at the central bank’s policy meeting, disappointing investors anticipating a more definitive sign of further monetary easing.
Though the “jury’s still out” on the ECB’s ability to achieve a swift resolution, Draghi’s pledge may mark a move in the right direction, said Morgan Stanley’s Secker.
“There’s more two-way risk for European equities now than there’s been in some time,” Secker said. “Europe is not just a one-way bet down.”
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