Interactive Investor

Markets look like a stretched rubber band. Here are the opportunities and risks

The valuation attractions of two countries may tempt investors back, argues Morningstar's Gavin Corr.

21st August 2023 09:48

by Morningstar from ii contributor

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Rubber band stretched tight 600

This year has once again delivered many surprises, twists and turns, and thrown up many opportunities and potential risks. We have seen much attention and excitement over whether we have reached peak inflation, the state of the Chinese economy, and AI-driven tech rallies, most notably in the US where a few companies powered the US index higher.

Many equity markets are touching all-time highs as investors have begun to price in the likelihood of a near-term peak in inflation and consequent interest rate hikes, and as corporate earnings have held up remarkably well. As always, this broad picture belies considerable differences below the surface as not all regions are in the same place on those trends. 

For example, the US, where inflation has fallen dramatically, AI enthusiasm is most focused, and economic growth is recovering, has seen the greatest interest from investors. This has resulted in the valuation of the US equity market becoming even more stretched in aggregate index terms.

In contrast, China, the UK, and Germany are facing different dynamics with sluggish growth in all three countries and stubborn inflationary pressures, particularly in the UK. While the Chinese economy’s travails are well known, having struggled to recover after its extended pandemic lockdowns and with the headwinds it faces from de-globalisation and the onshoring of production for security of supply reasons, the pressures facing Germany are less often discussed. The country is Europe’s economic powerhouse, accounting for 25% of Europe’s GDP and it has been the beneficiary of huge trends around globalisation that we have witnessed over three decades. 

German manufacturing companies have been exporting success stories in almost all industries as they have fed the modernisation and industrialisation of many emerging economies. The country was also a huge beneficiary of the enlargement of the European Union, with the free movement of labour helping to power its production and increased affluence across Europe providing ready markets for its products.

The fall-out from Russia’s invasion of Ukraine, where Germany is particularly vulnerable due to its reliance on Russian oil and gas, has been tumultuous for the German economy. As inflation has resurfaced over the past 18 months, and European and emerging markets have both seen economic growth stall, this has had an impact on Germany’s growth outlook. In addition, its biggest industry, car manufacturing, has seen market share eroding due to the shift from combustion engines to electric vehicles, with Chinese and other players stealing a march on their German rivals.

These concerns over the outlook for Germany have been reflected in the relative valuation of its equity market versus its global peers. Data from Morningstar shows Germany is the second-cheapest major market behind China, which is the standout cheapest market, and is only marginally cheaper than the UK.

The market is presenting us with some interesting opportunities from a valuation perspective, which is something that would have been hard to believe in previous years given the strength of its economy and strength of its companies. Two of Europe’s largest markets and economies, Germany and the UK, offer good value relative to their global, and even G7, peers, albeit with short-term issues that may hinder performance. But with the outlook for inflation looking better by the day, and with the fact that interest rates appear to be peaking, the valuation attractions of Germany and the UK may encourage investors back to these two markets over the medium term.

China is a trickier question due to corporate governance issues and very opaque government interventions, which makes the opportunity in Europe look potentially better from a risk/reward perspective.

Gavin Corr is head of due diligence and manager selection at Morningstar Investment Management Europe Ltd.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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