Value Favours Europe And Japan

Originally published by BetaShares

Due to relatively strong corporate earnings growth, the United States equity market has outperformed global peers in recent years. That said, with US interest rates – and to a degree the US dollar – starting to rise, there appear to be good prospects for catch-up performance by European and Japanese equities over the coming year or so.

Wall Street’s out performance largely justified by earnings

As seen in the chart below, US equities have performed particularly well since the global financial crisis, especially against European equities. Japanese equities, meanwhile, were slow to rebound from the financial crisis but in a furious three year burst had caught up with US equities by mid-2015. Japanese equities then corrected back sharply to fall back behind US equity performance.

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To a large degree, the relatively strong rise in US equities was fundamentally justified. As seen in the chart below, US forward earnings have clearly outpaced European earnings since the financial crisis. What’s notable, however, is that Japanese forward earnings growth has been as strong as that in the United States – despite Japan’s weaker pace of economic growth and greater deflationary pressures. This points to an important turnaround in corporate Japan’s focus on shareholder value.

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US stocks are relatively expensive

Notwithstanding the strong growth in US earnings, US equity valuations have also expanded relative to those of Japan and Europe in recent years. As see in the chart below, European equities have tended to trade at around a 16% discount (on a price-to-forward earnings basis) to US equities over the past decade or so, while Japanese equities have traded at a 14% premium. As at mid-March, European equities were trading a a modestly steeper 19% discount to US equities. Japanese equities, however, were considerably cheaper on historical grounds, trading at a 6% forward PE discount to US equities.

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Given cyclically weak European earnings in recent years, there is also arguably scope for catch-up earnings growth given ongoing signs of a European economic recovery and lift in inflation. Indeed, relative to measures of trend earnings, European equities are arguably even cheaper on a relative valuation basis to those of the United States i.e. valuations today are not reflecting a possible cyclical pick-up in European earnings growth. There are already some tentative signs of improvement in European earnings performance.