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Exorcising Chinese volatility from European equities

In the wake of August’s China-induced volatility, European equities are now finding a floor and should make headway into 2016 representing a potential buying opportunity for some investors. What’s more, the economic backdrop in the developed world remains reasonably encouraging. Unemployment continues to fall, income growth is good, and real income growth is even better considering the slump in commodities prices and the low level of headline inflation. Based on these positive drivers, the case for investing in European equities may be increasingly attractive, says Stephen Macklow-Smith, head of strategy for European equities, JP Morgan Asset Management.

A US rate rise would demonstrate the Fed’s belief in US growth

The European Central Bank and the Bank of Japan are still in the middle of quantitative easing programmes, short rates remain very low, and even though a turn in the Fed funds rate is expected this year, the US Federal Reserve (the Fed) has been at pains to emphasise that any tightening will be gradual, and will leave rates lower than in a normal cycle. But the Fed is not going to run the risk of a policy mistake, so a rise in the Fed funds rate would represent a healthy vote of confidence in US growth by the central bank.

Specifically in Europe, consumer confidence is still improving, Purchasing Managers’ Indexes are above 50, German industrial orders are growing well, and for all that Greece accounted for about 90% of headlines in June and July, Greek GDP is about 1.0% of European GDP, and its stock market is no longer investible, having been reclassified as an emerging market. (Source: Purchasing Managers’ Index, Institute of Supply Management, September 2015).

The market has been spooked, but may be overreacting

Meanwhile, the impact of the China situation on earnings and the economy is fairly limited, and we should also remember that although China’s growth is slowing, it is still growing faster than any other developed market (with the exception of Ireland).

The market has clearly seen a ghost, but it’s not clear whether the scale of the fall is justified. What’s more, this latest episode felt very similar to the one we underwent in October last year, with a steep initial fall followed by a V-shaped recovery.

Cause for cautious optimism on European equities

On the valuation front, the market is still below its long-term average Shiller price/earnings ratio, with earnings expected to grow by around 10% next year. As we get closer to year-end, the forward valuation will start to look correspondingly more attractive (this largely explains the well-known seasonality in stock markets).

Policy-makers remain firmly focused on sustaining the recovery, so that the financial system can continue to heal itself, and there are no signs of overheating in the real economy. Flows into Europe (ex UK) are still positive and there is still a long way to go before everyone is overweight the region. This is grounds for optimism, even if we see volatility along the way.

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