European equities – why we’re optimistic about returns

We believe the key determinant to future stock market returns will be earnings growth. And, judging by the very strong Q1 earnings season and the potential for GDP growth in the region, there is much to be optimistic about.

For context, since last year’s sell off, the stock market rally has been led by a sizeable expansion in valuations. Twelve-months forward price earnings (PE) ratios recently touched 17x in February, meaning investors were prepared to pay 17 times projected earnings for European corporates. This compared to a pandemic low of less than 11x in March 2020 and only 15x immediately prior to the pandemic in February 2020¹.

Perhaps the most striking aspect of the recent results season was how strong European earnings have been compared to other regions, despite relatively stringent lockdown restrictions being in place across much of Europe.

With Euro Area GDP still 5% below pre-pandemic levels, earnings have recovered back to 2019 levels, according to recent Morgan Stanley research. We believe earnings should be well supported in the medium term too, as economic growth turns from a headwind to a tailwind.

What has driven this strong recovery in earnings?

When we analysed the combined results, we made a number of observations, including:

1. Companies continue to benefit from COVID-related cost savings, e.g. reduced spend on travel, marketing and entertainment
2. The ‘base effect’ was of COVID struck Europe in 1Q20 and so the region was due a bounce
3. Sales have hardly contributed to the improvement to date, as shown in figure 2. While overseas markets have undoubtedly helped European corporates, renewed lockdowns in much of mainland Europe in 1Q21 hurt domestically generated earnings 

This last point is where we see an opportunity for Europe. As economies re-open some one-off costs will naturally rise from low levels, not to mention commodity costs are also increasing.

However, while we remain mindful of these developments, the critical determinant of future earnings from here is the European GDP recovery, in combination with continued economic progress elsewhere, and the positive effect this has on sales.

As lockdowns gradually loosen, we would expect European GDP growth, and therefore sales growth, to rapidly accelerate from here.

Notable economists, including the European Commission, are upgrading their GDP forecasts on the back of improving vaccine rollouts across Europe. The gap to the previously bullish growth forecasts, such as from Goldman Sachs, is closing rapidly. Either way, economic activity is set to ramp up significantly this quarter, in our view.  

It is also important to appreciate the sensitivity of European earnings to GDP growth. A 100 basis points increase in sales-weighted GDP (weighting GDP by end regional market revenue exposure) results in a 10% change in earnings. 

Is consensus too conservative?

As our calculations below show, earnings are already back to pre-pandemic levels and, according to consensus, are expected to remain at this level for the remainder of the year.

However, is this adequately incorporating the improving economic data in Europe? We think this may actually be overly conservative, even including cost inflation. In our view, the sensitivity of European corporates earnings to European and Global GDP is far more important. 

When emerging from recessions, forecasting earnings is even more difficult than usual. As such, it shouldn’t be a great surprise if the recovery in earnings is underestimated, even more so given the unprecedented nature of the current crisis.

Not only are we optimistic that European earnings can be a good deal better than currently expected this year but also that this is only really the start of a strong period of earnings growth.

More reasons to believe

Typically, Europe performs very well, better than many other regions, when we have a sustained period of above trend global economic growth.

We believe such an economic environment is about to re-emerge once again, in part due to the unprecedented policymaker response to the pandemic. The fiscal taps have been well and truly turned on, supported by easy monetary policy.

The effect of these actions is likely to be felt for some time to come. Such a scenario should be very supportive for European earnings, reflecting the cyclical and international nature of European corporates.

At the same time, European companies are well placed to take advantage of emerging structural changes, specifically climate change, digitalisation, and social inequality. We believe these should provide substantial opportunities for long-term growth with European based companies more exposed to these trends than many other companies from other regions around the world.

Read more about European equities.