Investors should look to Europe when making their next move

Open this photo in gallery:

Equity investors in the past five months have already enjoyed the kind of performance that stacks up very nicely over a full calendar year.

Many broad equity markets have appreciated impressively since the start of 2021. The MSCI World Index of developed country shares kicked off June in record territory and has gained 11 per cent since January. For stock-pickers, far stronger gains have been generated by companies in the energy and financial sectors, which have been buoyed by the prospect of reopening economies and a healthy boost to their corporate profitability.

The speed of the rally in many areas of the equity market does raise concerns that further scope for gains might prove challenging. Even with hefty infusions of monetary and fiscal stimulus coursing through the broader economy, the extent of this year’s capital appreciation from equities suggests a lot of good news has been discounted by investors.

“[Equity] markets had a very good run in May and they look fully valued at the moment and are vulnerable to any negative news,” says Chris Watling, founder and chief executive officer at Longview Economics Ltd. in London.

Investor complacency is clearly evident, he adds, with “risk-taking at high levels, rich valuations” and “global economic growth rates likely peaking.”

So, should investors trim their sails and prepare for rougher water? In the near term that looks prudent. Taking a longer view, the shifts in equity markets so far this year bode better for European and global equities than for the U.S.

When it comes to Wall Street, the prospect of a sticky summer for investors should not be discounted. Attention is focused on when the U.S. Federal Reserve Board will signal that it is pulling back on its current full throttle of easy money, a shift that could spur another leg higher in 10-year bond market interest rates.

Since late last year, the appeal of owning faster-growing companies that dominate the S&P 500 has been dented by higher market rates. These reduce the value of future cash flows from the ranks of companies growing quickly, especially those that are non-profitable start-ups built on plenty of promise. Renewed pressure on technology shares that weigh on the S&P 500 is one possible outcome from a negative bond market reaction in the coming months.

True, higher interest rates signify a strengthening economy, and an improving bottom line for companies is an important driver of long-term equity performance. Wall Street analysts expect double-digit earnings growth over the remaining three quarters of 2021 for the S&P 500, according to FactSet Research Systems Inc.

So far this year, bullish market sentiment has been affirmed by higher than expected earnings from companies. The growth rate of profits seen peaking in the current quarter is due, in part, to the comparison with very weak earnings amid lockdowns a year ago.

A challenge for investors is whether lofty expectations for U.S. earnings growth over the rest of 2021 and into next year will still bear fruit when more companies are experiencing problems that may test profit margins and high equity valuations.

This week’s release of the Fed’s Beige Book, a survey of businesses across the country, revealed labour shortages and supply-chain disruptions. “Looking forward, contacts anticipate facing cost increases and charging higher prices in coming months,” it noted.

These issues will probably beset other economies and, in some countries, turning the pandemic tide remains acutely challenging. What sticks out is how outside of the U.S., equity markets have enjoyed a strong run. The story of the past month has been one of European and British shares outpacing the S&P 500 in both local and U.S. dollar terms. That shift has played out as recent flows in US-listed exchange-traded funds (ETFs) suggest there’s “room for international equity allocation ETF flows to accelerate,” says a Citigroup Inc. report.

Last week, the Euro Stoxx 600 Index climbed to a fresh peak. That leaves the market vulnerable to a pullback. Beyond near-term market squalls, there are grounds for taking a more constructive approach toward global equities that have long lagged behind the tech-driven performance of Wall Street.

One area that will probably determine whether Europe can now prove a better place to park your money outside of the U.S. is that of financials. Getting bullish on the sector in the past has been replete with false dawns. While Stoxx 600 banks, as a group, have risen 35 per cent this year, they still remain cheap when viewed in terms of the value of their balance sheets.

Accounting for the naturally higher pace of U.S. corporate profitability, Colin Moore, global chief investment officer at Columbia Threadneedle Investments in Boston, believes there is a case for international markets doing relatively better for some time to come.

“After a prolonged period of U.S. outperformance you should see Europe and emerging markets start closing a large valuation gap,” he says. “Global equities are relatively cheap versus the U.S. and that is the opportunity for investors.”

© The Financial Times Limited 2021. All Rights Reserved. FT and Financial Times are trademarks of the Financial Times Ltd. Not to be redistributed, copied, or modified in any way.