European investors ignoring upside potential of US equities

Despite the US being the world's leading economy with the largest stock market and also home to many of the world's most prosperous and innovative companies, many European investors remain structurally underweight in US equities. Whereas the MSCI All Companies Index currently has a 42% weighting for US equities, many European clients are failing to manage 10% in their portfolios.

However, with the US economy looking set for recovery, Wall Street resurgent, and valuations still looking reasonable, Tom Elliott, Global Strategist at J.P. Morgan Asset Management, explains why now is the time for investors to take a fresh look across the Atlantic:

Armageddon averted

"Along with other global equity markets, Wall Street has experienced a highly turbulent time in the last two years as investor confidence has been sapped by the global financial crisis," says Elliott. "However, since March of this year, market sentiment has improved dramatically. Government and central bank policy responses have prevented the financial sector meltdown that many investors feared, and appear to have laid the groundwork for economic recovery."

Supported by low interest rates

According to Elliott, the market's recovery from mid March can be seen as a pricing out of the worst case scenario (financial meltdown) followed by expectations of economic recovery and a continuation of very low interest rates. Valuations are currently typical for this stage in the business cycle, no longer compelling but equally still offering value. Elliott adds: "In addition, there is the prospect of large amounts of US domestic savings coming out of cash accounts and into the stockmarket as the outlook for rate hikes remains poor. This will help support the market, even if growth remains below trend for some time."

Earnings season expectations - the higher they climb...

After a good Q2 earnings season in the US, expectations for Q3 were set pretty high, with potential scope for disappointment. So it is pleasing that announcements have got off to a good start in the US. Of the 188 companies of the S&P500 that have so far reported, almost 80% have beaten expectations for earnings. It should also be noted that of these, 42% have beaten expectations by more than 10%. Cost-cutting by corporates remains a discernible theme, though improvements in top-line growth are also becoming evident with a healthy 43% of reported companies beating sales forecasts and only 26% disappointing. In Europe, with sales actually disappointing slightly, cost-cutting has been the primary driver of the good news.

Other positive news

The IMF, in its October ‘World Economic Outlook,' placed the US top in its list of G7 countries, as measured by forecasted GDP growth in 2010, with 1.5%. Private sector analysts expect growth of 2.4%.

Industrial production has shown signs of improvement in recent months as companies across America try to boost stockpiles of goods after reducing inventories at record pace at the height of the downturn.

Car markets have ramped up production following a boost to demand from the ‘cash for clunkers' car scrappage rebate scheme.

Challenges lie ahead

However, market challenges still lie ahead: The recent signs of improving top line growth could run out of steam if consumer spending and investment fail to gather momentum. Corporate guidance on sales growth, which remains weak at present, is likely to move firmly to the forefront of investors minds once the benefits of cost-cutting are exhausted.

Attractive opportunities exist for long-term investors

Elliott concludes: "Taking all these factors into account, the US equity market currently offers attractive opportunities for long-term investors to gain exposure to world-leading companies in the largest global economy. There are still concerns over the strength of recovery and there may be a long hard slog ahead. However, valuations, while not as cheap as they have been, remain reasonable, and ongoing improvements in earnings expectations should help keep them in check. Meanwhile overseas investors are being attracted to the US market by the supportive actions of the American authorities, who remain committed to ensuring an eventual recovery, however muted that growth may be in the shorter term."