However, despite the noise, now is not the time to doubt Europe. Why? The simple answer is that geopolitical concerns are masking underlying company improvement.
European markets have fallen as strains with the impact of Russian sanctions and lingering bank stability concerns resurfaced with the problems of Portugal’s Banco Espirito Santo. With these factors weighing on sentiment, it has been easy to overlook the significantly positive news buried in second quarter earnings season, which is that the European corporate sector is in improving health.
Year over year earnings growth in Europe was 8.4%, outpacing the US, which by comparison had 6.9% year over year earnings growth for Q2. This is the first time in five years that European earnings growth has been ahead of the US. 52 per cent of companies beat expectations, 12 per cent were in line with expectations and only 36 per cent missed. Overall there were solid signs of margin improvement. Larger companies are joining their small and mid cap peers in returning to growth, leading to further upgrades to corporate earnings.
Meanwhile, in contrast to the relatively moribund 2Q14 European GDP figures, which broadly disappointed already low investor expectations, the leading indicators remain supportive of the European recovery. PMIs remain above 50 (signaling expansion) and consumer confidence continues to rise (especially in Germany where GDP contracted marginally in Q2) despite the Ukraine situation. Corporate credit demand is also rising and we are seeing an easing of credit conditions for small and medium sized enterprises, which should presage an increase in private investment. The ECB’s targeted long-term refinancing operations (TLTROs) are also expected to stimulate the flow of credit.
Thus far this year we have seen currency headwinds blamed for muted earnings growth in Europe. In our view, a weakening euro, relative to the US dollar, will act as positive tailwind going forward, especially for companies with international revenues. In aggregate, approximately 50% of European corporates’ revenues come from outside Europe (in either the US or emerging markets). A weakening of the Euro should not only stimulate export demand as products and services become cheaper, but also boost accounting revenue through translation effects. Over the year-to-date, the Euro has been flat / slightly down against the US Dollar year-to-date, and if this continues through the year, the currency headwind to earnings will have significantly diminished.
The second half of the year should provide evidence that Europe’s recovery is gathering pace, and this will be important for bolstering confidence that earnings can in fact continue to grow, supporting valuations. The ECB’s stress test will be concluded, and we anticipate that this will remove any impediment to the flow of credit. On this score, the evidence from the ECB’s recent lending survey was encouraging, showing that demand for credit is rising and credit standards are loosening.
What does all this mean for investors? It’s important to remember against this backdrop of a road to recovery in European that valuations remain attractive and this is still not an expensive market, at least not compared to the rest of the developed world.
In our view, what you pay for an asset class is the defining feature of your return profile. The chart below compares current valuation of European equities (measured as cyclically adjusted dividend yield) compared with the subsequent 5 year annualised investment returns. The correlation between the two over more than 30+ years is incredibly strong. In other words, the lower the valuation, the higher the prospective returns. As the chart illustrates, the relationship is still forecasting very healthy 5 year returns for investors at today’s starting point.
Investors should remember that time after time when you buy below long term average valuation multiple, you tend to without exception get above long-term average return. When you consider these valuations against the improving backdrop for Europe’s recovery and the prospect of a thriving corporate sector, it’s hard to argue the market is not good value.