SINGAPORE (Jan 2): Schroders is of the view that Pan-European equities will continue to enjoy good prospects in 2018 – even after their recent gains brought long-term valuations close to historic averages, with the MSCI Europe index up 9.3% year-to-date (YTD).

In spite of ongoing geopolitical events such as Italy’s impending May elections and ongoing Brexit talks in the UK, the global investment manager sees volatility around political events as a potential buying opportunity for active managers to purchase undervalued stocks.

In a Tuesday note, Rory Bateman, Head of UK & European Equities, argues that the regional market has potential to be driven by three factors, namely: improving corporate profit margins, lower inflation, and falling correlations.

Against an improving economic backdrop in Europe, Bateman notes that firms in the region have been enjoying better pricing power and operational leverage, meaning that companies are able to produce more while keeping costs stable.

Due to the fact that corporate profit margins of these companies are still lagging behind those of their US counterparts, the equities head believes closing this gap is likely to be a multi-year process – which in turn, should provide opportunities for companies to exceed consensus earnings expectations.

“A further positive piece of news for stock market investors is that the spectre of deflation has faded but inflation remains muted. This is due to several factors, including demographic changes and disruption from new technology. We think inflation is likely to stay low, albeit higher than the ultra-low levels of a couple of years ago,” states Bateman.  

In Bateman’s opinion, a low inflation environment would underscore equities as a strong alternative to low-yielding competing investments while offering scope for a lower-equity risk premium, which would resultantly support a higher overall market valuation than the historical norm.  

Another important factor that could support equities near year, he adds, should be the declining correlations between sectors.

“We think the trend of lower correlation – both between sectors and within sectors – should continue. Many companies’ share prices are still artificially boosted by macroeconomic factors; others are legitimately supported by strong fundamentals. As stock correlations fall, we believe the market will clearly show which is which,” observes Bateman.

“This creates a more conducive environment for our investment approach, which is underpinned by stock-specific analysis. A world of lower correlations means superior returns should be achieved by selecting the right individual stocks, rather than focusing on broad macro themes.”