Recent months have reminded European equity investors of the dangers of credit and geopolitical risk. Trouble in Russia and Ukraine, along with questions over the health of eurozone banks, have led to a 10 per cent correction in European equity markets.
While earnings-growth estimates have fallen to 9 per cent recently from 15 per cent in January 2014, it seems such a downward trend may now be changing as we are witnessing an improvement in earnings momentum.
What is behind these improved earnings dynamics? In the first instance, foreign exchange is becoming less of a drag on profits, in part because emerging market currencies have strengthened against the euro. A number of European companies have talked about currency headwinds becoming tailwinds in the second half of the year, and even beyond.
More importantly, it appears that the outlook for global growth is starting to look brighter. PMIs in Europe have softened slightly in the last couple of months but remain firmly above the 50 level (and have been for the last 12 months). PMI’s at these levels are consistent with 2% GDP growth.
At the country level, much of the improvement in PMIs over the past year and a half have come from Spain and Italy, and we have observed numerous other improvements in these countries that give us further encouragement.
In Spain, the economic recovery has started to spread to the labour market, which turned positive in July on a year over-year basis for the first time in six years and recorded the biggest fall in unemployment since 2006. Evidence of this continued in late July as the Bank of Spain raised its growth forecast for the year to 1.3%. In Italy, the PMI rebound has been supported by the improved political stability considered crucial to passing reforms that would boost economic growth. However, the poor performance of the banking sector in the recent stress tests could weigh on confidence in the country.
The other important development has been the easing of credit conditions in the Eurozone. The European Central Bank’s quarterly lending survey showed that standards for loans to businesses eased for the first time since 2007 – lowering one of the most significant barriers to the region’s recovery. What’s more, demand for loans to households and businesses continues to rise.
However, while the overall signs are positive, credit and geopolitical risks will likely continue to rear their heads and, with this in mind, portfolios need to be protected through use of selective sector allocations. One way to achieve this is by focusing on areas of the market where we have greater conviction and visibility, typically those that offer historically lower risk via stable returns and good earnings momentum.
In the consumer sector, for example, this has meant moving from consumer discretionary, where the outlook is less certain, to consumer staples, home to a number of high-quality companies, but valuations have been challenging until recently. In particular, companies that sell beverages, food ingredients and household goods currently offer the best mix of growth and attractive valuations.
In addition, health-care valuations remain attractive, with recent mergers, acquisitions and asset swaps representing substantial progress toward creating an industry focused on high returns. The sector’s strong balance sheets, robust cash flows, low earnings volatility and focus on capital returns have proved an attractive home for increased investment flows into equity markets.
On the other hand, the performance of bank stocks, and Eurozone banks in particular, has ebbed and flowed in line with macroeconomic data. Slow growth in demand for loans and more stringent regulatory requirements mean that the industry is unlikely to return to levels of profitability seen before the financial crisis, and many banks will struggle to generate returns above their cost of equity. Where there is an allocation to banks, having a strong balance sheet is a pre-requisite for inclusion in a portfolio.
In 2015, notwithstanding a serious escalation in geopolitical or credit risk, investors with thoughtful portfolio allocations will be well positioned to benefit from the improving earnings outlook. Adopting the right diversified sector mix now and being selective about opportunities is essential to gain from Europe’s corporate catch-up with its US and emerging market counterparts.
David Lambert is a portfolio manager at RBC Global Asset Management