Earnings Growth Underpins our Solid Outlook for European EquitiesFeb 8, 2018

Some investors seem to be questioning whether there’s still room for additional growth in European equities, particularly if interest rates start to rise. The reaction of global equity markets in recent days suggests that the transition from a period of economic growth without inflation to one of growth with inflation is likely to cause market volatility. Still, Templeton Global Equity Group’s Dylan Ball suggests labour reforms across Europe should give many firms the operating leverage they need to drive further earnings growth during 2018.

In general, looking across Europe as a whole, we don’t see much on the horizon to derail our solid fundamental outlook.

Still, because some of these fundamentals—for example, industrial production (IP) and purchasing managers index (PMI) data—are doing so well, it may be hard to see significant improvements this year. On the other hand, we don’t see any reason to think they’d slow down.

We think the corporate earnings environment should continue to improve, and that’s where we’d be looking to see attractive year-on-year comparisons.

Potential Upside in European Earnings

Europe is only five or six quarters into its earnings recovery since the global financial crisis. That puts it three or four years behind the United States. So our analysis suggests plenty of upside potential in European corporate earnings.

Provided political risks remain low, we reckon it’s likely earnings in Europe will continue to improve.

In time, that should lead to withdrawal of quantitative easing (QE) or at least some form of quantitative tightening. Ultimately, we should see some kind of eurozone interest rate hike, possibly even in 2019.

The composition of European equity markets tends to be skewed towards financials and energy, which tend to be more inflation/bond-sensitive and yield-sensitive companies.

From a sector perspective, energy, materials and financials make up more than a third of the MSCI Europe Index.2 Many of these companies tend do well when inflation is rising and bond yields are rising because typically inflation nudges up commodity prices and financial companies tend to profit when the yield curve steepens.

So, a rising interest-rate environment should be positive for European earnings.

Operating Leverage is a Positive

On the other hand, we don’t expect European earnings to hit the highs of 10 years ago, because there is no longer the leverage in the banking system.

Conversely, there is a lot of operating leverage on the corporate side. Thanks to labour reforms in Spain, France and Germany (earlier in the decade), the cost base of European companies is much more flexible. That should mean these companies have a greater potential capacity to grow earnings through increased profitability.

Significantly, that kind of leverage is not on company balance sheets but is on their profit-and-loss (Pamp;L) accounts. Instead of putting further debt in the banking system and within the corporate world, we believe the upside is that profits will come from lower cost bases and perhaps from charging higher prices.

The US industrial base went through similar changes in the early 2000s and came out much more competitive. Europe is only just starting to go through this.

France and Eastern Europe Offer Potential Opportunities

French President Emmanuel Macron’s reform agenda, which encompasses not just labour practices but tax as well, should present some interesting ideas. As investors we’re looking there for opportunities that others in the market are not grasping.

Eastern Europe may prove to be an area of opportunity in the medium term. Recently we’ve found equities in that region to be very expensive. Corporate governance risks and political risks are higher than elsewhere in Europe, but valuations are higher so we believe it doesn’t really make sense to find ideas there; you can find equivalents in core Europe.

However, we expect the United Kingdom’s departure from the European Union (EU) to leave a considerable hole in the trading bloc’s budget, some of which will fall on eastern European member states to fill.

If that were to start to leave budgets in the likes of Poland, the Czech Republic, Hungary or even Austria feeling a little stretched, their equity markets could devalue a little bit. Certainly we’d consider that an opportunity to look for some bargains.

Further out, we’re looking at how to play some of the more domestically focused stocks in the United Kingdom.

One consideration at the front of our minds is: “At what point do domestic UK stocks start to look cheap?”

Echoes of the Past

I liken the current attitude to Brexit in the United Kingdom to the situation in 2008-2009 when most capital expenditure and corporate investment was put on hold.

It’s similar today: Until people know what the post-Brexit rules are, they are postponing investment, hiring and capital-expenditure decisions.

But the supply shock stemming from those decisions has yet to work its way through the economy and we don’t yet know what the implications of that shock will be on demand. The valuations of many UK domestic stocks are starting to reflect that pessimism. We think prices should eventually revert to the mean; the main question is timing.

So, we’re aware that it could soon be the moment to find some bargains among domestic UK equities.

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.The MSCI Europe Index captures large- and mid-cap representation across 15 developed markets countries in Europe. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.