Equities Attractive, Earnings Defy Data

By Alan Higgins, UK, CIO, Coutts

Key data & events this week: Monday, German IFO business climate; Tuesday, US Conference Board consumer confidence; Thursday, US gross domestic product; Friday, Eurozone consumer price (CPI) inflation.

Russian equities attractive

Russian equities have long been cheap, reflecting political risks and perceptions of corruption, but the current earnings valuation (price/earnings ratio or PE) based on forecast earnings of around 4 is low even by historical standards – its lowest since the credit crisis. Cyclically-adjusted PEs are lower relative to the MSCI World index than during the credit crisis. Comparing asset-based valuations, price-to-book (PB) is also low for Russia at 0.7, while MSCI World trades on a PB of 2.1 and PE of 15.

In terms of other valuation metrics, the average dividend yield for the Russian market is historically high at 4.8%, which compares to 2.6% for MSCI World. Dividend cover in Russia (the number of times dividends can be paid from earnings) is very high in a global context. Profits look to be stabilising and Russian companies generally remain cash rich. Recent economic data also suggests a more stable outlook for Russian earnings and economic growth. In particular, the leading economic indicator has improved throughout 2014 and recent business activity surveys suggest expansion.

Less positively, high inflation (currently 7.5%) and the need to defend the ruble bias central bank policy towards higher interest rates, which could hinder economic recovery. And while evidence of a US-led improvement in global economic growth continues to mount, rising tensions between Russia and the West could continue to weigh on demand for equities and other risk assets.

While a major escalation of the crisis cannot be ruled out, there are significant incentives for Russia and the West to resolve their differences. Most notably, several European countries – including Germany and Italy – remain heavily dependent on Russian energy, while Russia is heavily dependent on Western capital.

We believe the potential for a re-rating of Russian equities over the next three to five years outweighs the risk of further near-term volatility. Markets historically perform well when geopolitical tensions ease. Even if forward PEs only returned to around 6, their average since President Putin came to power, that would still represent significant upside.

Equities | European earnings defy mixed macro data

European companies have delivered strong earnings despite mixed economic signals. The latest purchasing managers’ indices (PMIs) published last Thursday suggest that while manufacturing activity is mostly still expanding (PMIs above 50), confidence may be starting to wane, with PMIs falling to 50.8 from an unusually low peak of 54.

Yet despite the lacklustre macro backdrop, corporate Europe has delivered one of the strongest earnings seasons since the height of the debt crisis in 2011. Earnings margins at that time fell rapidly towards credit crisis levels. However, since the beginning of 2014 earnings have recovered and margins expanded, in the current quarter surpassing their five-year average. Margin growth supports our continued preference for European equities, which also remain more attractively valued than US counterparts.

Bonds | High yield fundamentals remain intact

High-yield bonds corrected sharply in July/August as many retail investors exited what had become a heavily-bought market. We believe a combination of government bonds and equities offers more attractive risk-reward potential than high yield, although the fundamental attractions of high-yield bonds remain intact.

We favour separating the different risk elements contained within high-yield bonds into their individual components. Specifically, we prefer to gain interest rate exposure through government bonds and equity exposure directly through equities (although equity and high-yield bond prices often move in tandem). High-yield bonds still have a role to play in portfolios but we are looking for cheaper valuations at which to add exposure.