The Europe Downgrade

  • The vulnerability of European equity at this time is defined by the downward revision of expectations of profit growth just as the stimulus to equity valuation from the fall in the cost of debt in the region is coming to an end.
  • It can now be said that European equity has been downgraded. Investor expectations have become more modest. The deterioration of confidence in European equity has become a bullish signal. Europe’s economic recovery is not going into reverse. Nor should we witness the resurgence of credit risk.
  • We want to re-iterate the “fully invested” message. We are reducing our portfolio liquidity ratio from 3% to 2%. We think that European equity should recover from this week through the summer.

Recommended sector and market asset allocation

The vulnerability of European equity at this time is defined by the downward revision of expectations of profit growth at a time at which the stimulus to equity valuation from the fall in the cost of debt in the region is coming to an end. The consequence has been the out-performance by defensive stocks and under-performance of European equity relative to credit and relative to the US market. The internal counterpart is the completion of the valuation return-to-mean of the region’s non-financial domestically-dependent equity assets, including the markets of the EZ periphery.

The deterioration of confidence in European equity has become a bullish signal. It can now be said that European equity has been downgraded from a comparative international perspective. Investors are aware that aggregate EPS growth for the region this year may not be much more than 5%. Investor expectations have become more modest. Defensive stocks are becoming expensive again. However, Europe’s economic recovery is not going into reverse. Nor should we witness the resurgence of credit risk on any significant scale. The BES affair is a throwback rather than a precursor. There is comparatively low risk of sustained investor selling at this time. Money should stay in the market. The worst fears of investors about earnings downgrades will probably not be confirmed in the imminent reporting season. We want to re-iterate the message of remaining “fully invested” at this time. Bond markets tell us that we have not yet reached the dangerous period for the equity asset class in general. We are reducing the liquidity ratio of our recommended portfolio from 3% to just 2%. We think that European equity should recover from this week through the summer. We are not adopting a more aggressive, less defensive asset allocation at this point. We do not yet have a catalyst from the forex market to upgrade industrial cyclicals. It is too late in the investment cycle for us to envisage rerisking the portfolio to any significant extent, at least in respect of smaller cap stocks. The message is the market rather than the portfolio.

Weightings and asset allocation for the MSCI Europe Universe



14/07/2014 Neutral weight in MSCI (%) 2-yr beta values
(vs MSCI)
Tactical sector rating Recommended allocation (%)
Consumer Discretionary 10.2 1.1 OW 12
Automobiles & Components 3.4 1.5 OW 4
Consumer Durables & Apparel 2.5 1.1 OW 3
Consumer Services 0.9 0.9 OW 2
Media 2.0 0.9 UW 1
Retailing 1.3 0.9 UW 1
Consumer Staples 13.5 0.7 UW 12
Food & Staples Retailing 1.4 1.0 UW 1
Fod Beverage & Tobacco 10.4 0.6 N 10
Household & Personal Product 1.7 0.7 N 2
Energy 9.7 0.9 OW 11
Financials 22.0 1.3 N 22
Banks 11.4 1.3 N 11
Diversified Financials 3.7 1.4 N 4
Insurance 5.8 1.2 N 6
Real Estate 1.1 0.9 OW 2
healthcare 13.0 0.8 N 13
Healthcare Equipment & Services 1.1 0.6 N 1
Pharmaceuticals & Biotechnology 11.8 0.8 N 12
Industrials 11.2 1.1 UW 10
Capital Goods 8.5 1.1 UW 7
Commercial Services & Suppy 1.2 0.8 UW 1
Transportation 1.4 1.0 OW 2
Information Technology 3.2 1.1 UW 2
Software & Services 1.5 0.9 UW 1
Technology & Hardware Equipment 0.9 1.3 UW 0
Semiconducors 0.8 1.2 UW 0
Materials 8.2 1.2 N 8
Telecommunication services 4.9 0.9 OW 6
Utilities 4.3 0.8 N 4
Exposure to risk
(beta value)
  1.01    
Lquidity ratio   2% (3%)    
* The exposure to risk is measured by the weighted average of 2-y betas.
We manage the liquidity ratio within a 0-10% rank.
Source: Kepler Cheuvreux