Two observations on markets this week — the first on the Eurozone equity markets, the second on FX markets. We’ve seen a strong rally in many European stocks over the last few months, partly based on sentiment. There’s a sense that a recovery is well under way and that the ECBs quantitative easing has helped. But much of the rally is also based on hard numbers — increased earnings. According to analysts at SG we have to go back to 4Q10 to see such a high number of companies reporting EPS above or in line with consensus expectations (73% according to Bloomberg). Strong positive momentum in share prices has helped push up valuations. Looking at forward valuation ratios, the S&P 500 P/E is now at around 17.7x , close to an all-time peak. According to SG analysts “ the eurozone does not seem cheap vs the 10y average, but it is just bottoming out from a lost decade since the 2008 crisis. The current eurozone P/E of 14.7x is still 10% below the 2015 peak, the P/B of 1.6x and P/S of 1.0x are respectively 26% and 14% below their 2007 peaks”. These headline numbers suggest that Eurozone equities might still move higher, especially as the political environment is stabilising.
But much also depends on what happens next with FX markets which will, in turn, have a big impact on corporate earnings — and relative valuations. We’re some way into a strong dollar rally and at current level’s it’s hard not to believe that the dollar is overvalued, especially considering the obvious political risks. Quite why the Trump administration hasn’t said anything about the strength of the dollar is beyond us — it impact on US exporters is obvious. Surely the administration must be hoping for a weaker dollar? If this does happen the obvious winner would be the Euro which is arguably undervalued. If the ECB does start to slow down the pace of its asset purchase programme we could see the Euro strengthen considerably, which could, in turn, weaken Eurozone earnings growth. One last observation. Global investors are still underweight emerging market assets. If central banks in the developed world start to scale back their intervention and ‘normalise’ we could see a renewal of the carry trade buying into higher-yielding currencies