The unveiling of details on bank stress tests in Europe will help clear a cloud overhanging global financial markets, enabling investors focus on the attractive valuation some assets are offering. World stocks, measured by MSCI, traded sideways for much of the past week as optimism from robust second-quarter earnings ran into concerns about a soft patch in the US economy.
Europe will publish on July 23 findings on how 91 banks would fare if economic conditions turned worse, identifying which banks need to raise capital. Comments from policymakers so far indicate no explosive outcome is likely.
Like US tests announced in May last year, the results of the tests may help open the door for private capital to return to the banking sector, mitigating fears that the financial sector is on the brink of collapse.
This may in turn encourage investors to go bargain hunting, especially after some risk asset classes show attractive value after a recent sell-off.
"We believe the tests could be the circuit breaker to stop the negative feedback loop between sovereign and systemic risks," Gregory Peters, strategist at Morgan Stanley, noted.
"Positive economic news and stress test results would go a long way towards reducing uncertainty. Aside from the direct benefits this should have on financial markets, it could also be positive feedback that encourages investors and companies into more 'risk-on' activity." The bank is most overweight in Europe in its global equity allocation because of attractive valuation. Barclays Capital prefers to be long credit heading into the stress results, which it says would improve confidence in the financial system.
The latest reading on Europe's manufacturing sector due in the coming week could also fuel a positive view, given that such sector surveys and equity performance have a high correlation of 78 percent, based on Barclays calculations.
The MSCI world equity index is still down 4.5 percent since January, having risen more than 31 percent last year.
Yet corporate performance has been upbeat this year. The Q2 earnings growth rate for firms listed on the S&P 500 index stands at 27.6 percent, with seven percent of them having reported.
Next week will bring more key second-quarter earnings, including IBM, Bank of New York Mellon, Goldman Sachs, Apple and Johnson & Johnson.
"You could well see a very strong Q2 earnings season in which case fund managers are very poorly positioned for that," said Gary Baker, head of European equities strategy at BofA Merrill Lynch.
The BofA survey on fund managers has found that investors view equities as the cheapest relative to bonds since March 2003.
Investec Asset Management believes that equities globally are showing exceptionally good value, based on a prospective price earnings ratio for 2010 near 13 and a 2011 ratio below 11. "The downside to equity markets appears very limited in valuation terms and the upside could be considerable," Investec said in a note to clients.
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