Europe
Although employment and growth remain weak, we have seen improvements in data, particularly within Germany and Spain. Positive economic surprises and PMIs continue to trend well, especially relative to other regions (Figure 8). Fiscal austerity is also becoming less of a drag, although the Syrian refugee situation could create new economic pressures on the region. We are closely watching for signs of flagging business confidence in the wake of well-publicized company-specific misfortunes in autos and mining. But if consumer and business confidence remain resilient, we’d expect fundamental economic data to remain resilient as well. Euro zone companies should benefit from this stabilization as well as from several tailwinds to earnings, including lower commodity prices, lower rates reducing funding costs and a weaker euro improving competiveness of exports, which should drive margin expansion.
While the relative performance of the European equity markets has weakened recently, we are still seeing attractive valuations relative to other regions. These valuations, combined with a positive liquidity environment and resilient-to-improving economic fundamentals, support our overweight positioning in our global and international portfolios. We continue to identify exporters that can benefit from a weaker euro. We are carefully monitoring individual companies’ end-market exposures, particularly when those end-markets are experiencing decelerating growth. Many of these companies operate within the industrials, consumer staples and health care sectors. Within financial services, we have identified opportunities among high-quality banks but have focused primarily on real estate, which is benefiting from the lower-rate environment and economic recovery, as well as asset managers and insurance. We remain largely underweight in energy and materials.
Japan
Japan’s economy continues to face challenges. Positive economic surprises have trended down, with less encouraging data in wage growth, industrial production and exports. Given these headwinds, we would not be surprised to see a fiscal/monetary response. We are concerned that Prime Minister Abe may be limited in his ability to advance key economic reforms, given the amount of political capital that he had to expend in support of defense initiatives, but the cost is arguably offset by the benefits of an increased economic relationship with the United States.
Still, we are optimistic about the prospects for Japanese equities, where valuations remain relatively attractive. Many Japanese companies are less dependent on top-line growth to drive earnings surprises as evidenced by profits that have surged over recent years with very little help from revenue growth (Figure 9), and we see bottom-up opportunities for continued improvement in margins and returns. As we have discussed in our blogs, we believe management teams’ new focus on cost management and improved capital allocation should provide significant catalysts for earnings growth. Japanese companies should also benefit from lower energy prices and corporate tax rates. In our view, these tailwinds, combined with the pending Trans-Pacific Partnership (TPP) trade agreement, should drive increased competitiveness in several industries.
We are generally positioned equal to overweight to Japan across most of our portfolios, with an ongoing focus on secular growth opportunities and companies that we believe can benefit from improved corporate governance, capital allocation policies, a weaker yen and asset reflation expectations. We are finding these opportunities primarily within the industrials, consumer, information technology and financial sectors.
Emerging Markets
Over the near term, we do not believe a hard landing for China is the most probable outcome. However, there are likely to be challenges along the way as China navigates the complex transition from an investment-led economy to an economy more dependent on consumption and services. As we have noted in the past, the Chinese government has a variety of tools to prevent a sharp eceleration in growth. Over recent months, we’ve seen monetary policy become more accommodative, additional infrastructure stimulus announced and fiscal stimulus meant to support the housing and auto industries. While we do not expect these measures to spark a reacceleration in growth, they could contribute to a stream of stabilizing data (as we have seen with PMI, as shown in Figure 10) and improve sentiment around the Chinese equity market (for more on this, please see our recent blog). Additionally, we do not believe China’s decision to “reform” the renminbi signals China’s intention to exacerbate a global currency war. To us, it appears China is attempting to quell market concerns by supporting the renminbi at current levels, at least until the IMF makes its decision on including the currency within its special drawing rights reserve in November.