Japan and Europe Shake Off the Economic Doldrums

In light of improving economic fundamentals coming from Japan and Europe, should investors keep a close eye on both regions?

For the past two years, we at the Global Investment Committee (GIC), Morgan Stanley’s team of seasoned investment professionals, have anticipated a rebalancing of global growth which would hand-off global equity market leadership from U.S. to non-U.S. stocks. Although this global rebalancing thesis has faced periodic headwinds it continues to advance.

International equities have now outperformed U.S. equities since July, corroborating our thesis. While emerging markets (EM) have been the outperformers thus far, there is now increased conviction that Japan and Europe will begin to participate more fully in the global rally given that both equity and macro fundamentals are picking up.

With respect to Japan, the potential for yen weakness, earnings stability and fiscal expansion makes us more constructive. Hans Redeker, Morgan Stanley & Co.’s chief currency strategist, forecasts the yen weakening to 112 to the dollar from today’s 105 by 2017’s second quarter.

Such a move, coupled with already improving earnings revisions, would bode well for Japanese stocks (see chart below). Furthermore, macro factors, such as manufacturing PMI, industrial production and export volume, are making gains.

Earnings Forecasts Improve in Japan and Europe

To be sure, our view on Japan is more bullish than the consensus. Jonathan Garner, MS & Co.’s chief Asia and emerging markets strategist, underweights Japanese equities based on earnings disappointments, sluggish growth, and skepticism about the effectiveness of Japan’s monetary and fiscal policy.

In our view, much of this has already been priced into the market, which is why the MSCI Japan Index trades at 14-times forward 12 months’ earnings—in the bottom 5% of historical relative valuation. We recommend hedging 50% of the currency exposure; for the unhedged portion of a Japan allocation, we favor active managers, who should continue to capitalize on idiosyncratic trends.

In Europe, stocks have long faced headwinds such as disappointing earnings, ailing banks, deflationary pressures and now, the UK’s vote to leave the Euro Zone. That said, relative earnings revisions have recently inflected higher and economic conditions are beginning to improve.

A key reason why European equities have lagged is the region’s struggling banks. The MSCI Europe/Banks Index has underperformed the broader benchmark by 19% during the past two years. Recapitalization of troubled banks is critical, but it may take time; in the interim, we see the recent cyclical upturn in Europe continuing, which should buoy performance. The MS & Co. Europe Cyclicals vs. Defensives Basket is up 18% for the year to date. Importantly, the macro backdrop in Europe is also brightening.

While German bunds are pricing in no economic growth, Euro Zone data have improved recently. Manufacturing PMIs have ticked higher, as have key economic surveys and the Citi Euro Zone Economic Surprise Index, which has risen since mid- September. The upturn in the MS Global Trade Leading Indicator is a plus because trade has historically accounted for as much as 40% of Europe’s GDP.

Furthermore, European companies generally have more operating leverage than U.S. companies, so every incremental improvement in GDP has a greater impact on earnings.

Finally, negotiations around a UK exit could begin by the end of March 2017. Ultimately, we see policymakers responding to a possible “hard” Brexit outcome, a mostly complete break from the EU, with a combination of monetary and fiscal stimulus. The Brexit vote has had a positive impact on the UK stock market as a weaker pound has benefitted UK companies. We would consider taking profits in UK equities, which have outperformed since Brexit in local currency, but we recommend maintaining exposure to the Euro Zone.

This article first appeared in the November 2016 edition of “On the Markets,” a publication of the Global Investment Committee, which is available on request.