Markets & Finance

S&P: Green Light for European Equities?


Though the major indexes remain choppy, a recent note from Standard & Poor's suggests that sentiment has improved in Europe and a silver lining could be not too far ahead in the future.

In a Sept. 22 note, S&P sought to gauge European investor sentiment by combining seven variables, including the so-called iTraxx Crossover rate and the U.S. housing market, to look at the market's potential direction in the short term. Its investment policy committee (IPC) determined a sentiment level of 51.4 (on a scale to 70), up from 42.9 two weeks before, suggesting that markets in Europe could be poised for gains.

S&P chief European equity strategist Clive McDonnell spoke with BusinessWeek.com's Alex Halperin about why the improved sentiment might encourage U.S. investors to take another look at Europe. While this indicator is promising, he cautions that it must be considered in a broad context. Edited excerpts of their conversation follow.

Why was there such a large jump in S&P's sentiment gauge recently?

There were four factors that resulted in the improvement in the ratio: the euro/yen exchange rate, leading indicators of U.S. inflation, geopolitical risk, and indicators of a hard landing in the U.S. They're the ones that saw an improvement in their rating, which led to a rise in the ratio.

To take a step back, the reason behind this sentiment indicator is that, in our view, for the usual key drivers of European equities, there's a fair degree of certainty about the outcomes over the next six months. We know that earnings are going to slow. We know the economy is going to slow. We're quite confident about that [since] tax increases will be one predominant factor. And third, there's no dispute over rates rising. There are a number of traditional drivers of European equities, but they are certainly three of the key ones. And given the degree of certainty over those, it requires investors to consider what other factors could be driving equities over the next six months.

Discussions in the IPC group resulted in seven factors being highlighted. Most of them are actually outside Europe, but it puts the emphasis on how important nondomestic factors are in guiding the market over the next number of months.

So you see this as about a six-month forecast?

It is short term and very important to emphasize that. What the sentiment indicator indicates may well differ from what our strategic fundamental long-term view is. But we think there could be a lot of ebbs and flows over the coming months and given that the traditional drivers are not going to help in terms of the ebb and flow of the market, that's why we came up with these additional [ones]. But they shouldn't be used in isolation, they are short term and they relate to sentiment as opposed to specific index values.

Given those conditions, what should small investors take away from this?

There has been an improvement in the near-term outlook. That, in combination with the forecast decline in the dollar against the euro, means for U.S. investors now is an opportune time maybe to consider some reallocation. I know that [S&P's] U.S. IPC has increased its strategic long-term allocation to international equities. But from a shorter-term point of view, some of the key factors have turned more positive. So there is an agreement among some of the U.S. strategic allocation factors and these shorter-term factors.

Why is the iTraxx Crossover rate the most positive factor?

Somewhat counterintuitively in my mind, it shouldn't be so positive. But in the iTraxx Crossover rate, which looks at a basket of triple B minus bonds and lower [non-investment grade], we have seen the expectations of the impact of liquidity being drained out of the market, leading to an uptick in defaults and a rise in credit spreads. Even though liquidity has been drained out by central banks, the crossover rate, which is derived from credit spreads, has actually continued to decline. So we've identified different levels of the iTraxx Crossover rate as being either a signal that investors are becoming more risk-averse or less risk-averse.

That dictates which side of [a] five [rating] you're on. And depending on these other factors we could have a score of, if it's signaling quite positive for spreads, we'd be at six or above. Each member of the IPC has responsibility for one indicator, and our banks analyst feels that the current signal that's coming from the iTraxx Crossover is quite positive.

Is this data able to translate well into specific sectors or is it more of a general mood?

It certainly doesn't translate, unfortunately, into specific sector recommendations. It is simply sentiment relating to the market overall. But I think it's interesting to know that last month the score was somewhat negative—42.9—and between Sept. 6, when that number was released and when it was revised, the market basically went nowhere. Although we were signaling that the market would decline, at least the market did not rally.

A question that many investors ask is: What's the track record like for this sentiment indicator? It doesn't lend itself to back-testing. The euro/yen exchange rate is something that's come into vogue at the moment. Twelve months ago it was the euro/dollar [exchange rate], so fluctuations in the euro/yen would not have had such an important impact on the market. But at the moment euro/yen is relevant. It's at elevated levels, shall we say, nearing 150, although it has come back somewhat. So we are giving it a score that's just slightly in negative territory.

So you're willing to swap factors in and out as they're relevant?

For a short-term index like this, we've set these for the coming months because we think these will be what the key drivers are. But if in six months' time—I'm speculating—if the ECB [European Central Bank] were to start cutting rates or if growth was much worse than expected or even much better than expected, logically it would require either a change in the weighting of these factors or more likely a change in the composition of the seven indicators.

M&A continues to be a source of strong performances. Does that complement this index?

No. M&A is a very important theme in the market but it's a secular one. It's not something that appeared two months ago and we expect it to disappear in two months' time; it is a secular trend that we expect to continue. Hence, I don't think month-to-month fluctuations in M&A will have a significant impact on the market. The overall view is that M&A is helping valuations in selected sectors. Just because the number of deals announced dips in a particular month, it doesn't mean the M&A story is over. Other factors could derail it, but at the moment it remains pretty much on track.

Is there any read across from this sentiment index to your long-term view?

I would say not. The drivers of the long-term index forecast and the sentiment index are radically different. The drivers for the long term include earnings forecasts, what we think margins will be and what's going to happen to ROE [return on equity]. Those sort of issues are driving our long-term forecast.

But fluctuations in the euro/yen are very much on a day-to-day basis. For example, even if we think the dollar is going to weaken against the euro, that is somewhat negative for European equities but the euro/yen as a driver is shorter term, and it's fluctuating.


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