While investors are focused on the Fiscal Cliff negotiations in the United States, events in Europe demonstrate that the continent is still not out of the woods. Despite aggressive actions this summer by the European Central Bank (ECB), lowered growth forecasts in Europe, along with the impasse over the aid package to Greece, underscore the long and rocky path ahead for Europe. I continue to favor northern European countries, such as Germany and the Netherlands, but now we can add one more to the list: France.
I am upgrading France from a neutral or benchmark holding to an overweight (potential iShares solution: EWQ). The main reason is because French equities are now looking attractively valued. At a price-to-book multiple of 1.14, France is 14% below its 5-year average, and is offering a 31% discount to the MSCI World Index, and a 15% discount to Germany.
Most of Europe enjoyed a decent rally in the aftermath of the ECB announcing its bond purchase program in September, but equities have since fallen, with France underperforming. As of November 16, French equities are down 3.7% since August while Germany is down 1.1%, Italy is down 2.2%, and Spain is down 0.2%.
True, France’s growth prospects look lackluster, with a forecast of 0.4% (recently revised downward) by the European Commission and IMF. Still, in our view, the “recession discount” is already priced in. Those concerns have been fueled by worries that the government’s ambitious budget, which aims to cut the fiscal deficit to 3% in 2013 mostly via tax increases, could trigger a deeper recession.
Meanwhile, worsening news out of Germany, in particular lower growth forecasts, has increased the odds that EU policymakers are more willing to let the ECB operate on looser monetary policy to support growth. Ironically, that, in turn, could disproportionately benefit French equities.
Make no mistake, downside risks remain within the banking sector. But the broad French market is well diversified with no single sector accounting for more than 16% of the MSCI France Index, and the deep discount in non-financial sectors compared to peers in Germany and the rest of developed Europe is in our view hard to justify. And while expectations on corporate profits have been revised down steeply since the third quarter, the hurdle set for any upside surprise is now low.
Across Europe, the state of the financial sector is a concern. Indeed, I would balance the France overweight with European financial sector underweight in order to help mitigate specific risk linked to financial sectors.
With lingering uncertainty over the Greek bailout as well as the timing for Spain to request assistance through the European Stability Mechanism, I remain cautious on southern European equities. Instead, I look to the less sensitive and undervalued core markets. And I would include France in that category now.