I know we shouldn’t be using the word “overweight” as we approach the holidays. But take heart that this blog won’t be an attempt to guilt you into eating less. Instead, we use the term in the far more positive sense in relation to a country, and to a region, that our CIO team currently like.
The region is Europe, where we have been arguing for some months that a combination of an improved macro environment, positive earnings growth, and still cheap valuations make this swathe of developed markets relatively attractive. But, drilling down a little further, there lies at the heart of Europe a single country that we are also positive on (an over-weight within an over-weight, an obese-weight?). That country is Germany, and there are two key reasons why it’s favored.
The first is that the German stock market is an export-heavy beast. According to FactSet, just 23.4% of its revenue is derived domestically. Or, put another way, more than three quarters comes from sales abroad. And this accords with intuition. The largest sector of the German market is Consumer Discretionary, which accounts for about 18.6% of market cap. Within that sector, Automobiles are the largest component accounting for 11.5% of market cap (and therefore about 62% of the sector itself). And we all know the behemoths we are talking about here – BMW, Daimler, Volkswagen, Porsche – brand name auto firms that are selling cars across the world.
What’s the linkage though between this high proportion of exporters and a belief that the German equity market will continue to do well? The key is the euro, where our house forecast is for a depreciation over the course of the next year to EUR/USD 1.10. A weakening currency directly benefits exporters who can exchange now stronger foreign currency earnings into more of their domestic currency, thus boosting income.
If a weakening euro could provide a catalyst to improved earnings it’s also reassuring to know that that hasn’t really translated yet into an over-valued market. And this is the second point. Figure One shows the ratio of Price-to-book (P/B) for MSCI Germany and MSCI USA. It was calculated as Germany divided by the U.S. so the lower the line, the cheaper Germany is when compared to America. We also put in the average ratio over this period which was 0.62. It’s clear that the valuation gap has closed somewhat recently but it’s still below the average suggesting that investors wouldn’t yet have to worry about overpaying for German exposure, at least relative to the U.S.
Of course, there are reasons for caution too when it comes to Germany. An obvious one is that the recent elections have arguably weakened Chancellor Merkel’s position and added uncertainty to the macro landscape in Germany. Additionally, a more dovish U.S. Federal Reserve (Fed) and/or a more hawkish European Central Bank (ECB) could lead to a continued strengthening of the euro which would hurt exporters in the opposite way we described. Finally, while valuations are a useful tool for gauging the relative attractiveness of assets, they can play out over very long periods, longer, potentially than an investor’s time horizon.
But, at least, as we head into holiday season, these are two over-weights that won’t hit your waistline.