European stock markets have suffered a decade of marked underperformance amid an ongoing earnings depression, but might 2017 be the year that the long-awaited turnaround in corporate profits finally materialises?
Investors could be forgiven for giving up on the prospect, having endured a Godot-like wait for an earnings rebound.
Hopes were especially high in early 2015, when European equity indices soared after the European Central Bank (ECB) announced an open-ended quantitative easing programme. Monetary stimulus, allied to a weak euro and low oil prices, was supposed to light a fire under stocks and deliver an earnings upturn, but it didn’t happen.
Instead, stocks fell heavily in the second half of 2015 and were flat in 2016, with European investors looking on enviously as US equity indices hit all-time high after all-time high.
US and European indices were pummelled during the 2008-09 financial crisis, but there’s no doubting which region has enjoyed the strongest recovery. Excluding dividends, the S&P 500 has gained more than 60 per cent over the last decade, compared to a decline of 20 per cent for the Euro Stoxx 50. Over the last five years, the US index has advanced 75 per cent, twice as large as the Euro Stoxx 50’s gain.
US equity valuations have been consistently higher in recent years, but it’s misleading to suggest that the gulf in performance has been driven by valuation multiples alone. Rather, the problem is that European companies “haven’t grown earnings in over half a decade”, to quote a recent Barclays research note. “At a time when US companies have managed to grow earnings to levels well above prior-cycle highs, European company earnings are still languishing near prior-cycle lows,” notes Barclays.
‘Depressing’ chart
A chart mapping European and US earnings over the last 30 years – dubbed the “most depressing chart in Europe” by Barclays – highlights the gulf. Over those three decades, US earnings have enjoyed more than a fivefold increase, almost twice as fast as the pace of earnings growth in Europe.
Importantly, the two regions largely moved in tandem between 1987 and 2008. Since then, however, a marked divergence has taken place. The underperformance of European equity indices, adds Barclays, “has been fully driven” by the shortfall in earnings.
Clearly, many investors don’t expect a 2017 breakthrough. Institutional investors are underweighting Europe, according to recent Merrill Lynch monthly fund manager surveys. Fund inflows in to the US have been very heavy since Donald Trump’s election victory catalysed the reflation trade, but European sentiment remains muted: 70 per cent of the money that flowed into Europe in 2015 had left by December 2016, according to Credit Suisse data.
As well as stagnant earnings, investors are concerned by the potential for political tensions in 2017, in particular the prospect of gains for anti-establishment parties during the Dutch general election in March, the French presidential election votes in April and May, and the autumn German federal elections.
Nevertheless, many strategists are optimistic that 2017 will mark an inflection point for European earnings. Merrill Lynch expects 2017-18 will be the “best years for European earnings since the global finance crisis”, projecting profits will rise 11 per cent in 2017 and a further 8 per cent in 2018 on the back of an improving European economy, a weak euro and a bullish outlook for commodity prices.
Similarly optimistic noises are being made by Goldman Sachs, which says that Europe is “very open”, with the Euro Stoxx 50 more “representative of global growth” than the US. Easy monetary policy and euro weakness are also supportive factors, argues Goldman. Barclays, too, is positive, predicting an 11 per cent gain for the Stoxx 600 in 2017.
In Barclays’ “blue-sky” scenario, favourable political outcomes could drive an index gain of as much as 18 per cent. Overall, however, Barclays says investors should focus on “earnings over elections”.
Earnings stagnation: why?
The big question is, why have European earnings been so poor for so long? European companies have been less active in repurchasing shares than US firms, says Barclays, but that only accounts for a small part of the earnings differential. Other commonly proffered explanations are similarly inadequate. “Both real GDP and sales have recovered to levels now exceeding prior cycle highs,” says Barclays, with European company sales broadly in line with US revenues over the last five years. That’s quite remarkable, given the earnings gap relative to the US is “still at multi-decade highs”.
If sales are fine, profit margins are anything but. “For the first time since 1990, European profit margins have stagnated at a time when US margins have improved,” with Barclays data showing the profitability gap “is the widest seen during this time period”.
One obvious explanation is that the S&P 500, unlike European equity indices, is a technology-heavy index; tech companies enjoy tasty profit margins, in contrast to the financial and commodity-focused sectors that characterise European indices.
Even if one excludes financial and resource stocks, however, European profit margins are “very low compared to historical norms”. Similarly, tax rates or interest costs do not explain Europe’s low profit margins.
The problem is inflation, or rather the lack of it in recent years. Pricing for European firms has grown at a much slower pace than previous cycles; sales have been impressive due to companies “sacrificing on pricing to maintain volumes”. European companies’ prices “appear to depend heavily on the prevailing inflation environment” – they are “price-takers rather than price-setters”.
Global inflation numbers appear to be more important for European pricing than euro area inflation, reflecting European companies’ high international exposure. Accordingly, while attention has largely focused on the US when it comes to assessing the benefits of global reflation, Europe may be best placed to benefit from a pick-up in inflation. The expansion in profit margins, says Barclays, could have a “dramatic” impact on earnings.
Inflation in the euro zone hit 1.1 per cent in December – the highest level since 2013, noted Standard & Poor’s (S&P) last week. December saw European economic confidence hit its highest level since March 2011, the firm added, while Citigroup’s economic surprise index for the euro zone rose to its highest level since February 2013.
The problem, as contrarian types might point out, is that this improved economic outlook is at least partly reflected in market prices. Citigroup’s aforementioned economic surprise index is regarded as a contrarian indicator: very negative readings are associated with market bottoms while very positive readings can portend near-term market falls.
Indeed, it might seem odd to suggest that European indices could be tired, given that 2016 was a flat year, but it was a year of two halves - the Euro Stoxx 50 has rallied more than 20 per cent since June’s market bottom.
Valuations
As for valuations, the picture is a nuanced one. According to JPMorgan’s latest quarterly Guide to the Markets, various valuation metrics indicate French and German equities are slightly expensive relative to their recent history. Even in countries such as Italy and Spain, which are often characterised as cheap markets, valuations are largely in line with historical norms.
Additionally, the uncertain political outlook means many investors will demand a margin of safety before investing in Europe, and it seems prudent to assume that valuation multiples will not expand to any great degree over the coming year.
Still, while European equities may not be in bargain basement territory, they are certainly cheap relative to the rest of the world. Developed European stocks currently trade on a cyclically-adjusted price-earnings (Cape) ratio of 16.6, according to German firm Star Capital. The US, in contrast, trades on a Cape ratio of 26.
In the past, European stocks have delivered above-average returns over the following 15 years following periods of comparably valuations. In contrast, the median annualised US return has been just 4.1 per cent following periods of elevated Cape readings.
Cape has its critics, but other valuation metrics confirm this valuation gulf. For example, Europe trades on a price-book ratio of 1.8, compared to 2.9 for the US. Accordingly, Star Capital projects that investors will earn annualised real returns of 7.2 per cent over the following 10 to 15 years, compared to just 4 per cent for the US.
This is echoed by Barclays. Financial stocks, which tend to trade on lower valuation multiples, have a high weighting in European equity indices but valuations remain unthreatening even if one adjusts for this weighting; the median stock in Europe trades in line with historical norms. Risk premium measures “continue to look elevated” and “severely negative” fund flows suggest “depressed positioning”.
In a nutshell, an earnings recovery is not “priced in”, says Barclays. That’s good news for investors willing to take the bet that the five-year stagnation in European earnings is – finally – ending.
