This earnings season confirmed that the average company continues to struggle in the current macroeconomic environment and added a new variable to worry about: emerging market exchange rates. The latter was behind a number of fairly disappointing results.

Why had analysts again forgotten about the impact of FX? I do not know. It seems that they think it is below them to mark to market their forecasts for something so trivial. Their inability to do so guarantees further downgrades as the effect of the EM currency crisis will not wash out before mid 2014.

The jaw between valuation and earnings has continued to widen, with share prices up 3.9% last month on average but earnings forecasts down 1%. The situation is now worryingly stretched. Over the last 12 months, share prices are up more than 15% whereas earnings forecasts are down 18% (16.5% ex financials), and the preceding 12 months had shown exactly the same pattern.

Investors initially ignored this divergence as they thought that the key factor was the stabilisation of the Euro zone, which allowed the correction of the excessive pessimism in equity valuations. However, we have been two years into this phase and we surely need something else to sustain the rally.

Though, the European economy has finally emerged from recession and there are a few bright spots (US and UK namely), the fiscal headwinds on the continent and the currency crisis in emerging markets will weigh down on growth next year.

I doubt that economic growth will be high enough to warrant the 14.5% increase in earnings (ex financials) that analysts are forecasting for 2014. This is the reason why we will continue to favour in 2014 growth stocks, turnaround situations and short cycle companies.

In the meantime we will have to navigate the treacherous waters of the “silly season”. This is how I call the period which starts at some point in November and ends in the course January, when investors bet that magically things which did not work in the past will start working when we move to a new calendar. I am sure that many investors in fact are not so naïve in believing that this magic really works but quite cynically they think that everyone will play as if.

There is no better sector than steel to encapsulate the spirit of this “silly season”. Here we have a sector which has proven to be a value destroyer on an unbelievable scale. Companies have never managed to earn their cost of capital in a sustainable way. Though, this has not prevented them from ploughing more good money after bad one into it, either via acquisitions (Arcelor Mittal) or pipe dream projects at the other end of the world (ThyssenKrupp). In spite of this dreadful record, the sector has outperformed the index 10 out of the last 13 years at the turn of the year (December/January)… to lose all the gains and more in the following eleven months. Everyone knows this but everyone plays the game nonetheless.

We will try to ensure that our fundamentals driven process does not suffer too much during this “silly season”.

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Lionel Rayon

Lionel joined Schroders as part of the acquisition of Cazenove Capital in the summer of 2013, having been at Cazenove since 2005. He is a senior member of the pan-European equity team and manager of the Schroder ISF* European Alpha Absolute Return (circa $1 Billion AuM). He is also responsible for developing and maintaining a fundamental and valuation screen of European stocks. The screen forms the basis for generating ideas for potential further detailed investigation by the European team within the framework of their disciplined Business Cycle Approach. Lionel joined from Citigroup where he was a Director in the European Tech Research Team. Prior to Citigroup, Lionel had been with Schroders Securities, as a French specialist, Nomura Research Institute, as a metals & mining specialist, Enskilda and Chevreux de Virieu. Lionel graduated from Indiana University (MBA) and Institut d'Etudes Politiques de Paris (BSc economics & finance). He has 20 years of equity research experience.

Website: www.schroders.com


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