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We release our Q3 outlook today and one of the questions we asked in it was if European equities could start to outperform their US counterparts over the next three months?

The first thing we looked at was different measures of valuation, on that basis it appears that European stocks are priced appropriately for the current level of political risk and weakness in the growth outlook. However, US equities may start to look expensive if 1, concerns about the fiscal cliff and political squabbling in Capitol Hill start to grip the markets' consciousness and 2, if the growth outlook continues to deteriorate in the coming months.

On a price-to-book value basis, European stocks look cheap relative to their European counterparts, as you can see in the chart below. However, there are fundamental reasons why Spanish stocks should be priced at less than one times book value, compared to US stocks, which are two times book value. Spain is mired in a recession and in the middle of a sovereign crisis. However, we know about that. Weak growth is pretty much a given for Spain at the moment, and the sovereign crisis continues to muddle through. Although Spain is likely to remain mired in recession for some time, especially now that Spanish PM Rajoy has announced even more austerity measures and a hike in VAT, financial markets have been well prepped that growth in the currency bloc is likely to be weak-to-negative for some time as it de-levers on an enormous scale.

In contrast, weak growth signals in the US, including a sub-50 ISM manufacturing reading for June and a sharp drop in payrolls growth in the last three months, may start to weigh more heavily on US stocks, especially if Q2 earnings are poor and corporate outlooks for the rest of the year are bleak.

Source: and Bloomberg

The ratio between the SPX and the IBEX also may have peaked in early June, and since then has been on a downward channel, thus US stocks may have become less resilient in the current climate relative to their European counterparts. The decline in this ratio may continue, especially if the Federal Reserve doesn't look like it will try to cushion the US economic decline with more QE. US equities may then have to weather the economic storm on their own, which could be negative for US equities.

SPX/Ibex ratio


Source: and Bloomberg

This doesn't mean that a long Ibex trade will work; we believe a relative value trade is a better way to take advantage of a potential further decline in this ratio. Thus, we look to go short the SPX at the current level of 1,340 (you could wait for 1,360 if you want a better rate), while we look to go long the Ibex around the 6,770 level - the recent low. This trade idea is a slow burner and one we look to play out over the course of Q3.

A caveat to this, of course, is 1, a disorderly break-up of the currency bloc in the next three months and 2, a sovereign bailout for Spain (in addition to the banking bailout). We don't rule out further official aid for Spain, but don't think it will materialise in the coming months.

Best Regards,

Kathleen Brooks| Research Director UK EMEA |

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