The uncertainty that the unwinding of U.S. quantitative easing creates is coinciding with an earnings reporting season that is challenging the elevated level of implicit corporate profits growth now discounted in markets. The transmission mechanism of rising levels of QE benefited developing markets and currencies and various “carry trades” for a number of years, so the decelerating pace of the stimulus is inevitably going to cause a few perturbations. The global nature of European companies inevitably exposes some of them to the weakness in emerging market currencies and lower sales growth in these countries. Many of these companies, however, have local sales matched with local production, so the impact on profit will not be as severe as many fear. After more than two years of underperformance by the MSCI Emerging Markets index against the World index, it could be that we are at the height of concerns on the developing stock markets and that some time a contrarian stance might be warranted on exposure to these economies.
A few modest falls in the index and the return of a bit of fear in the minds of investors is a healthy thing: it focuses attention back onto the financial merits of individual companies rather than the quest for pure top-down factor exposure and naked risk taking. The earnings cycle might have been tepid so far, but looking forward we should see earnings momentum start to accelerate in Europe, even if it is driven initially by the base effect of easy comparisons with previous years.
How long and how far the current correction will go is hard to judge but, given the diminishing number of attractively priced companies, lower stock prices and greater uncertainty are to be welcomed. Valuations had returned to near pre-crisis levels and this was not only for quality names, many of which have actually derated recently as investors have chased recovery names ever higher. A hiatus, therefore, is needed to allow value to return and for uncertainty to create a larger number of exploitable market inefficiencies. In an environment of limited value, earnings momentum and the ability to deliver positive surprises for investors, along with sales and profit growth are increasingly the differentiating characteristics of successful stocks.
The message from the corporate coal face remains mildly constructive: economic conditions have stabilized and are improving slowly, confidence is strengthening, but things certainly are not booming. But who needs a boom anyway? They tend to be followed by busts, so a nervous recovery based on improved corporate competitiveness and gradually improving investment is preferable to liquidity led euphoria. A bit of fear and uncertainty helps return value and inefficiencies to the market – exactly the conditions that stockpickers relish.
Andrew Parry is CEO of Hermes Sourcecap, London.