The following is excerpted from monthly commentary by Merrill Lynch Wealth Management.
As we approached mid-month in May, the conflagration around the Eurozone crisis has flared once again, sending equities reeling. BofA ML's European equity strategist, Gary Baker has noted that European Forward price/earnings (P/Es) are now below 10 times, which is quite low versus a long-run average of 13.4 times, and nearly a standard deviation cheaper versus the (depressed) two-year rolling average. And the European dividend yield of 4.2% means European equities now yield 2.75 times the 10-year German bund (1.54% as of May 9), which is an all-time high ratio. While European equities do look quite oversold and offer increasingly attractive yields, we remain concerned that it may be early to make a significant investment in the broader European equity markets. We recently reiterated an underweight recommendation for the region, noting that economic growth remains weak, while consensus earnings expectations look too high.
We remain concerned about the potential depth of the current recession in Europe, as many of the weaker countries fight for growth while dealing with forced austerity. Issues in Greece, and political uncertainty across the region, may further weigh on markets in the near to medium-term. The risk of further bank contagion is real if Greece chooses to exit the euro. Although we agree that risks in the region are formidable and that the complexity of a workout plan has been taken up a notch by populist politics and the potential rejection of austerity measures, the recent fear trade has created compelling values among some of the world's “best-of-breed” companies.
One area that may be primed for opportunities for patient investors is among those “best-of-breed” companies from Germany. While some recent economic data suggest Germany has begun to feel the impact of sliding economies across the rest of Europe, we believe Germany will continue to exhibit the region's strongest growth based on its solid, export-led industrial base. Indeed, as German policymakers increasingly seem to acknowledge the need to allow some inflation and higher wage growth, this could potentially improve consumer spending.
Germany's first quarter GDP report surprised to the upside, coming in at 0.5%; the rest of the Eurozone is in recession territory. Interestingly, despite strong recent outperformance by German equities versus the rest of Europe (e.g., in euro terms the MSCI Germany has outperformed the STOXX 600 by 7% year to date through May 11), German P/Es remain roughly in-line with the rest of Europe. Indeed, while Germany has significantly outperformed the weakest peripheral Euro countries (e.g., equally weighted average of Greece, Ireland, Italy, Portugal and Spain, or the GIIPS), its forward P/E is virtually in-line with that group, with all the outperformance coming from relative earnings growth. While the 3.8% yield on German equities is not as high as Europe as a whole, it is also attractive. German equities yield more than 2.5 times the yield on the German 10-year.