Why European equity valuations should approach the US

Transcription

1 Insights Monthly update on an Markets October 2017 Why an equity valuations should approach the US Summary Hot Topic. Over the last 20 years, the an market has traded at a valuation discount to that of the US, ranging from a historical high discount of 39% today to a low of 10% in December One reason that is often cited is sector mix. While the US has a relatively higher weighting in Technology and Consumer Discretionary and a lower weighting in Financials, a sector-neutral valuation still results in a sizeable 3 valuation discount for (see table 1). Looking deeper, financial theory suggests that valuation (Price-to-Book, PB 1 ) is a function of dividend growth rate, profitability (in terms of Return on Equity, ROE), and the cost of equity (COE). We believe that structural factors embedded in both the ROE and the COE contribute to the valuation gap. Table 1. Price to Book: versus US 2017 US Discount Price to Book (PB) 1 3,1 1,9-39% PB ex Financials 3,6 2,3-3 PB ex Financials & Technology 3,3 2,1-3 Sources: HSBC Global Asset Management, Factset, UBS End of September 2017 (1) Price/Book Value Ratio = (ROE - g) / (COE - g) ROE = Return on Equity g = Growth of cash flow or dividends COE = The cost of equity is the rate of return required by the company's ordinary shareholders in order for that investor to bear the risk of holding that company's shares. The return consists both of expected dividend and capital gains. PUBLIC This commentary provides a high level overview of the recent economic environment, and is for information purposes only. It is a marketing communication and does not constitute investment advice or a recommendation to any reader of this content to buy or sell investments nor should it be regarded as investment research. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of its dissemination. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns.

2 Hot Topic. Why an equity valuations should approach the US Over the last 20 years, the an market has traded at a valuation discount to that of the US, ranging from a historical high discount of 39% today to a low of 10% in December One reason that is often cited is sector mix. While the US has a relatively higher weighting in Technology and Consumer Discretionary and a lower weighting in Financials, a sectorneutral valuation still results in a sizeable 3 valuation discount for (see table 1). Looking deeper, financial theory suggests that valuation (Price-to-Book, PB) is a function of dividend growth rate, profitability (in terms of Return on Equity, ROE), and the cost of equity (COE). We believe that structural factors embedded in both the ROE and the COE contribute to the valuation gap. Dividend growth: Favors over US Since the end of 2003, an and US companies have grown dividends by 180% and 80% respectively. Even since the low of the financial crisis in 2009, the dividend growth rate of an companies has been three times that of US companies. ROE: an margins to improve Indeed, US companies have generated a superior ROE compared to an companies (see figure 1 below). Figure 1. Return on equity: versus US ROE (%) Source: Factset End of September 2017 DuPont 2 analysis decomposes ROE into the components of leverage, asset turnover and net margin. The first two factors are similar for versus US, especially after excluding Financials. Therefore, net margin is the more relevant driver of the ROE difference (see figure 2). The US may have enjoyed higher margins due to the following factors, which we would expect to normalise over time: 1. Operating leverage: US volumes have increased with economic recovery, entering a growth cycle that is extended over nine years, while an companies have lagged as the economy only recently started to accelerate. 2. Taxes: US effective corporate tax rates were 1% lower than an rates and have been 3% lower since We expect more an countries to announce corporate tax cut programs. 3. Interest rates: US corporate interest rates have declined much more than an rates since 2006 given the earlier and more aggressive quantitative easing (see figure 3). Interest rates should start to converge with the US Federal Reserve embarking on gradual normalisation while the an Central Bank (ECB) has indicated it would not start to raise rates before 2019 at the earliest. 4. Market concentration: American companies tend to enjoy a higher market share as they serve a larger and more homogeneous domestic market though market concentration is difficult to shift quickly. Figure 2. Net margins ex financial 10% 8% 4% 2% 0% -2% USA 7% 5% 4% Figure 3. Interest cost, as % of debt 3% USA US non-financials an non-financials Sources: HSBC Global Asset Management, Factset, UBS End of March 2017 Source: Factset End of March 2017 (2) DuPont analysis is a method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are measured at their gross book value rather than at net book value to produce a higher return on equity (ROE) The commentary and analysis presented in this document are according to the information available to date. They do not constitute any kind of commitment from HSBC. Consequently, HSBC will not be held responsible for any investment or disinvestment decision taken on the basis of the commentary and/or analysis in this document. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecast, projection or target. The content of this page is not intended as an advice or recommendation to buy or sell any sector or financial instrument. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. 2

3 Hot Topic. Why an equity valuations should approach the US COE: Small effect The cost of the equity is the risk premium that an investor is willing to accept to hold equity. While US companies have enjoyed a persistent COE advantage of about 0.5% (see figure 4), it only explains one-fourth of the overall valuation discount according to UBS. The three main reasons for the lower COE are: 1. Deeper capital markets and USD s role as the world reserve currency 2. Lower volatility of the US equity market 3. Lower taxation of capital gains versus dividend. On the latter point, US corporates favor share buy backs over dividends, enabling investors to pay a lower 15-20% tax on capital gains versus the 35-40% rate on dividends (treated as ordinary income). While share buy backs do mechanically boost earnings per share, Modigliani and Miller capital structure theory 3 suggests this should not matter in a world without taxes. Figure 4. Cost of equity: versus US 14% 12% 10% 8% Sources: HSBC Global Asset Management, Factset, UBS August 2017 Conclusion Differences in net margin is the apparent reason behind the historically high valuation gap between an and US equities. With the an economy beginning to accelerate, and with changes in taxation and interest rates, we would expect an corporate margins to improve, driving an equity valuations higher and closing the valuation gap with US equities. (3) Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. US The commentary and analysis presented in this document are according to the information available to date. They do not constitute any kind of commitment from HSBC. Consequently, HSBC will not be held responsible for any investment or disinvestment decision taken on the basis of the commentary and/or analysis in this document. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecast, projection or target. The content of this page is not intended as an advice or recommendation to buy or sell any sector or financial instrument. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. 3

4 Euro Fixed Income. Outlook & overall portfolio positioning Euro credit markets were remarkably resilient for the third quarter of Despite the lack of visibility on Brexit negotiations, tensions with North Korea, the movement for Catalonia independence, speculation on a possible replacement for Janet Yellen and upcoming elections in Italy, credit spread volatility (as all Euro risky assets volatility) remained at all-time lows. Only sovereign yields saw some limited tension ending the month roughly 10 bps higher. Euro credit markets are backed by strong demand, good corporate fundamentals, low inflation and a resynchronization of global growth. The market appetite easily absorbed the high level of issuance in the primary market with more than 21.8 bn issued by an companies in September. Outlook. We remain under-exposed to rate duration; though we expect headline inflation to remain below the ECB target through the forecast horizon, inflation recovery continues. Our fundamental equilibrium model spots a fair value close to 0.90% for the 10Y German Bund and we expect it to reach levels around 0.60% by the end of the year. With regards to our credit exposure, while remaining constructive, we stay close to neutral to slightly underweight as we acknowledge that valuations are starting to be stretched on both an absolute and historical basis. We continue to take advantage of generally stable to improving credits with positive technical factors for an credit despite the growing sensitivity of spreads to risk-free rates. We are very selective on the primary market as the premium versus secondary market is generally low. We continue to prefer short duration subordinated debt from high quality issuers. Data watch: 8 Oct Indicator Date Actual Consensus Previous data PMI composite Sept. F GDP quarterly, % QoQ Industrial production % YoY 2Q F % July 3.2% 3.3% 2.8% Unemployment rate August 9.1% 9.0% 9.1% Trade balance, monthly EUR Bn (12Mth cumulative) Retail sales % YoY Inflation: - Headline CPI, % YoY July August 1.2% % Sept. A 1.5% % - CPI core (1), %YoY Sept. A 1.1% 1.2% 1.2% ECB Refinancing rate Deposit rate 7 Sept % -0.40% -0.40% Asset Purchase Target ( billion) 0.00% 0.00% 0.00% (1) Eurozone CPI Core is CPI excluding energy, food, alcohol & tobacco Improved or better-than-expected data on month-on-month/quarter-on-quarter basis Worsened or below-expectations data on month-on-month/quarter-on-quarter basis Unchanged data or in line with expectations on month-on-month/quarter-on-quarter basis Analysis F: Final estimate A: Advanced estimate Despite the euro strength, the manufacturing PMI index reached its highest level since Feb. 2011, while the services index posted its first gain since April. These data signal GDP growth staying above its potential in 2H 2017, probably in line with its 2Q pace of 0. qoq. GDP growth accelerated in 2Q, with the year-on-year expansion revised up 0.1ppt to 2.3%, the highest in six years. All major subcomponents recorded growth. Positively, gross fixed capital formation, a proxy for investment, rebounded by 0.9% qoq after dipping 0.3% in 1Q. Exports moderated marginally (1.1% qoq; 1.3% in 2Q), while imports accelerated by 0.9% qoq (0.4% in 2Q). Industrial production strengthened again in July, now averaging a 3- month pace of 3.4% yoy, which reflects strong international and internal demand, underpinned by the cyclical upturn in investment. Unemployment rate held steady at 9.1% for the third consecutive month. Country-wise, the jobless rate fell in Germany (to a historic low at 3.), in Italy (11.2% vs 11.3%), but rose marginally in France (9.8% vs 9.7%) while remaining unchanged in Spain (at 17.1%). On a 12-month cumulative basis, the trade surplus (ex-eurozone) has been moderating from the record level held in Dec 2016 ( 266bn). This reflects very solid external and domestic conditions, with further acceleration of exports (5.9% yoy on a 12-month moving average from 4.5% previously) and a faster pace for imports (7.3% yoy against in the previous period). Retail sales moderated in August from the very strong pace seen over the past 12 months (2.3% yoy), and notably in 2Q (3% yoy). Employment gains, very favorable credit conditions and improving consumer confidence should remain supportive to private consumption in the region. Eurozone headline inflation came in unchanged at 1.5% yoy in Sept. Meanwhile, core inflation, the ECB s preferred measure, softened to 1.1% yoy, but keeps at a 9-month average pace of 1.0%, after 0.8% in 2015 and The ECB kept its policy on hold. ECB President Draghi suggested that a decision about the calibration of the asset purchase programme will likely be made on 26 Oct. Draghi also made clear that the governing council is concerned about the strength of the euro, which prompted the ECB to downgrade their inflation forecasts to 1.2% in 2018 and 1.5% in 2019, 0.1ppt below June estimates. GDP growth forecasts were left unchanged for 2018 and 2019 at 1.8% & 1.7% respectively, but raised for this year by 0.3ppt to 2.2%. Sources: Bloomberg, Datastream, Eurostat, HSBC Global Asset Management, as of 8 October The commentary and analysis presented in this document are according to the information available to date. They do not constitute any kind of commitment from HSBC. Consequently, HSBC will not be held responsible for any investment or disinvestment decision taken on the basis of the commentary and/or analysis in this document. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC accepts no liability for any failure to meet such forecast, projection or target. The content of this page is not intended as an advice or recommendation to buy or sell any sector or financial instrument. The performance figures displayed in the document relate to the past and past performance should not be seen as an indication of future returns. 4

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