Ahead of this weekend’s big EU summit Morgan Stanley Europe strategist Graham Secker takes a look at what to expect, and how the market is currently positioned.
As for the market he concludes: It’s cheap, and European investors are very bearish, but they’re not that bearish. If you think markets are currently pricing in the end of the world, you’re wrong.
For example, he notes that valuations, while low, aren’t at rock bottom levels.
Of course, the prospects of a relatively weak economic outlook are not lost on investors and help explain why current equity valuations and sentiment are low by recent historical standards
(i.e. over the 25 years). However, if the future economic environment is going to be considerably tougher than the last 25 years, then it stands to reason that equity valuations will
also be lower. In short, we think it makes more sense to look at equity valuations against as long a time frame as possible.
On this basis, we do not think equities are actually that cheap; for example, the consensus 12m forward PE for MSCI Europe is currently 9.1, which is predicated on 9.4% EPS growth over
the next 12 months. In contrast, we believe that a prospective PE ratio of around 10 is a good proxy for fair value through this cycle, and we currently forecast European profits to fall 6% in 2012. If we do assume that a 12m forward PE of 10 is fair value through the cycle, then Exhibit 2 implies that the market is currently pricing in a 1% drop in EPS over the next year – we believe it is hard to argue that a recession is ‘in the price’.
Photo: Morgan Stanley
Anyway, as for what markets need to see from Europe, well, there are a few things. Some progress on bank recapitalization, Greek haircuts, and fiscal integration would be nice, but…
A credible sovereign backstop is priority no.1
We do expect to see progress toward fiscal integration that is often perceived as a key step on the road to a more sustainable solution to Europe’s problems. However, we believe the primary focus for investors in the short-term should be the credibility of a sovereign backstop. An unsatisfactory resolution in this regard is likely to undermine any progress made across the other three factors, in our view.
All right Europe, let’s see what you got.