BofAML _ European Equity Strategy: Falling knife time

Redacción - Martes, 25 de Agosto

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•   Markets have reached extremely oversold levels. The question for investors is when to catch the falling knife.
•   We think that European equity markets now look cheap at 13.5x earnings and 3.7% dividend yield.
•   A snap back looks imminent but investors may still need a central bank catalyst.

Markets extremely oversold

Last Thursday we said European markets were getting oversold. We noted that it could go even further given that it is August and corrections "can always go further than you think". So it proved with the S&P 500 breaking down through key supports to close at the lows on Friday. Lacking a move on monetary policy from the Chinese authorities over the weekend, Asian markets fell sharply yesterday morning leading to heavy declines in European equity markets. The question for investors is when to catch this falling knife. Our inclination is that moment is coming very soon, although we may still need a central bank to act as the catalyst.

Investors have overreacted and too much seems priced in

As we publish the Eurostoxx 50, Stoxx 600 and Dax are all set to close flat year to date while the FTSE is nearly 10% down. Compared to April's market peak, the Stoxx 600 is off nearly 20%. Is it right that the impact of the ECB's QE should be totally reversed by the fallout from China? It is difficult to know for sure. However, our Chief European Economist Gilles Moec has tried to quantify the impact of China on European growth. He found that even a halving of Chinese growth would likely only knock 0.4% of Euro area GDP. The current data would seem to support the benign view with Euro PMI and, arguably as importantly given its exposure to China, German PMI rising in August.

Valuations now at a discount to historic averages

We were cautious in mid-April because markets were stretched and valuations looked full at more than 16x P/E (12 month forward). Price to earnings has now fallen to just 13.5x, just below the long term average. Yet this makes little sense in an environment where other assets yield so little and the Stoxx 600 dividend yield is at almost 3.7%. This is already an interesting entry point for longer term investors, in our view.

Can the central banks be the catalyst?

It is trickier for shorter term investors. Key support levels have been broken so it is very much like catching a falling knife. Get your timing wrong and it is going to hurt. But historically, when the market is this oversold, the turning point tends to be measured in days not weeks. Indeed, the last time the market appeared to be this oversold was August 2011 and October 2008. Both times markets fell sharply for a couple of days but then snapped back. We think the market is setting itself up for something similar here. The missing ingredient has been a catalyst. As we said last week, the central banks are the obvious ones. Quite why the PBOC has not eased policy since the devaluation is known only to them but, for the Fed and the ECB, the deflationary wave stemming from China is sure to be a concern. It is likely that they will react at some point.

 

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