Laurent Denize (ODDO BHF AM): Cheap reviews

06.10.2022 –

  • Even with the STOXX 600 at its lowest level since the Covid crisis, suitable entry points for a significant re-engagement in European equities have not yet been reached.
  • In the current uncertain geopolitical and monetary policy environment, it is crucial to focus on robust cash flows.
  • Certain growth sectors, for example in healthcare or some technology segments, open up opportunities. High-yield bonds also appear to offer attractive yield spreads again compared to government bonds.

With 380 points and a valuation of 10.4 (estimated 12-month P/E), the broad European benchmark index STOXX 600 reached its lowest level since the outbreak of the COVID crisis (March 18, 2020: 10.3). High-yield bonds are also down more than 15% year-to-date, almost as much as stocks. With this in mind, the question that arises is: are the current levels a good entry point?

P/E compression phase largely over

First, there is no direct correlation between valuation and future performance. For the performance of an investment over a 30-year period, it makes almost no difference whether the price-to-earnings ratio at the time of entry was above or below the historical valuation average of the STOXX 600 (ie a P/E ratio of 14) ) . However, valuations matter when extreme levels are reached. If you buy the STOXX 600 at a price-to-earnings (P/E) ratio of less than 10, there is an 82% historical probability of positive performance over the next 12 months, an average of 18%. To reach this attractive entry point, the STOXX 600 must fall by at least 5%, i.e. below the 360 ​​point mark. The P/E compression is therefore largely over; The question that remains is how the profit will develop (the “G” in “P/E”).

Future business results should be the focus

Analysts have already significantly lowered earnings forecasts for European companies. While a few months ago they expected that the earnings per share (EPS) would increase by 16% in 2023, today they expect an increase of only 3%, a level well below the inflation rate. It is important to remember that if sales volume remains the same, inflation will automatically increase sales in EUR. Considering the current falling real wages, this correction is quite significant. In addition, a global recession could cause commodity prices in Europe to fall faster and help limit the profit decline significantly in 2023. Moreover, the weakness of the euro does not only have negative effects. Companies exporting to the dollar area will achieve currency gains if they transfer their export earnings and exchange them into euros: a positive exchange rate effect of around 5% is expected. A 3% increase in earnings per share (EPS) for 2023 is therefore quite conceivable

Which sectors are particularly valuable?

In this environment of geopolitical uncertainty and rising interest rates, the priority should be predictability and robustness of cash flows. Not only does the healthcare sector generally benefit from a strong dollar, we also believe it offers an attractive risk/return ratio. As a result, several large European pharmaceutical companies (AstraZeneca, Roche, Merck) will be able to increase their sales by 4-5% in the coming years, generate good margins and offer correspondingly reasonable valuations (P/E of 14-15) . Within the technology sector, the software/IT services sub-segment (Cap Gemini, SAP) is becoming more attractive again after the fall in valuations. In addition, in our recent discussions with the companies, we could get the impression that demand is still relatively robust. Digital transformation remains high on the agenda for large companies that want to become more agile and competitive in the face of inflationary, logistical and economic uncertainty. Large software companies can also increase their recurring revenue by switching to cloud solutions. Capital-intensive and highly leveraged sectors with limited pricing, such as B. the telecommunications industry and regulated utilities, we remain cautious. Despite attractive valuations, we believe it is still too early to enter sectors such as consumer staples and industrials, as the downward revision in earnings expectations has not yet come far enough.

Still too early for a significant repositioning in European equities

Our conclusion is that investment decisions should never be made solely on the basis of valuations. However, it is also clear that European equities remain exposed to the growing risks of a global recession due to tighter financing conditions and aggressive central bank policies. Even with significant pessimism already factored in, rising real interest rates continue to weigh on risk premiums. Already, the fall in equity valuations has been more than offset by the rise in real bond yields. There is also a risk that the implied risk premium for global equities will fall back to their long-term average with the planned future rate hikes from the ECB. Against this background, we believe it makes sense to wait for the STOXX600 to fall below 360 points before repositioning into European equities on a large scale.

High yield bonds have a lot to offer

Although the risk of a recession is increasing, European corporate bonds provide an interesting alternative to equities in the short term. The segment is also attractive compared to European government bonds. European corporate bond yields have now risen enough to offer significant interest rate premiums over government bonds of the same duration. The risk of fragmentation remains, and Germany’s planned €200 billion program will widen what some see as disparities in the loss of purchasing power across economies. This could lead to anger in the EU. After all, a country like Germany has significantly more resources than e.g. Italy to mitigate the impact of the energy crisis (debt to GDP of 150% versus 69%). Moreover, the ECB is still far from ending its rate hike cycle. The cocktail of volatility and rising interest rates could make the market environment difficult for a few more months.

Within the bond segment, only high-yield bonds have a yield profile that approaches that of shares over the long term. In the euro area’s high yield universe, BB rated bonds have the highest credit quality and make up the largest part of the segment. With a yield to maturity (YTM) of 6.6%, they are 480 basis points above the yield on three-year German Bunds. For comparison: The risk premium for shares is 7.4%. In short, bonds are offering some benefits for the first time in many years. Finally some good news in this difficult environment: Kakast is celebrating their comeback!

Leave a Comment