By Robert Rountree
Public attention was certainly captured last January, when the European Central Bank announced its quantitative easing programme.
A strong equity rally, a declining euro and falling bond yields greeted the decision. Subsequent growth forecasts have been upgraded as optimism has grown that Europe’s “fix” is underway. It is a desirable dream, but déjà vu creeps in.
Haven’t we been here before? Isn’t there something we have missed? Doesn’t this sound familiar?
In fact, it sounds too familiar; we have been here before. The “dreams” eurozone investors are chasing are already manifest in Japan.
To begin with, let’s consider quantitative easing. Japan’s QE programme is more aggressive than that in the eurozone. By end 2016, the Bank of Japan’s balance sheet will amount to around 80% of GDP. The ECB’s will be well under 30%.
A major objective of the easier monetary policies is to drive the currencies down to competitive levels. How does the eurozone stack up on this score?
While the euro has fallen some 18%[1] from its March 2014 high, it is still some 15% above its 1985 and 2000 lows. In contrast the yen has fallen consistently since its 2011 peak and is at a 45-year low; it is ferociously competitive.
It is true that Japan’s exports have been slow in responding to this weak currency, but this is not necessarily bad as some have fretted. Japan’s exporters, for example, are competitive at ¥92[2]. With the yen trading at around ¥124, exporters are benefitting from wide margins – good for both profits and cash flow.
The picture also seems to be improving as both manufacturing and non-manufacturing orders are rising. Indeed, the weak post-GST performance of non-manufacturing orders disguised a steady uptrend in manufacturing orders. With both now on the uptick, we should see better new orders per se emerging in the coming six months. In short, Japan’s rise in physical orders is outstripping those in the eurozone[3].
There is little doubt that eurozone new orders will rise, but so far, expectations (as measured by the various purchasing managers’ indices) are running well ahead of actual delivery. Delivery is occurring in Japan, not just on new orders but also on most consensus sales and earnings forecasts[4].
An investor’s bottom line, however, is value. Has the potential been discounted?
When looking at composite valuation measures for both markets[5], eurozone equities have arguably discounted the better outlook in good measure. Earnings growth would have to be far higher than the almost 14% growth forecast for the coming 12 months[6] to bring valuations down to Japan’s levels (based on a higher, close to 16% earnings growth).
In short, while a eurozone recovery is underway, and earnings and profit forecasts will likely rise in 2015, one cannot escape the conclusion that much of this has been discounted.
In contrast, Japan is actually delivering. Those dreams increasingly reflect reality – a reality that has only partially been reflected in higher valuations.
Japan is living the dream.
Robert Rountree is a global strategist at Eastspring Investments
[1] As measured by the real effective exchange rate collated by JP Morgan from Datastream as at 23 June, 2015
[2] Economic and Social Research Institute, Cabinet Office – Annual Survey of Corporate Behaviour, FY2014 (Note: Fiscal Years ending 31 March).
[3] In the year to date, new orders for eurozone manufacturing (excluding heavy transport) rose some ¾%. In contrast, Japan’s machinery orders (excluding shipping) rose some 4½% according to the eurozone’s Directorate General of Economic and Financial affairs and Japan’s Cabinet Office respectively.
[4] As measured by IBES from Datastream as at 23 June, 2015.
[5] Source Eastspring As measured by the “Z” score
[6] As in 4. above.
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