Europe looks to have achieved some level of economic stability after almost a decade of uncertainty, but this has not yet been reflected in the share prices in the region. This article, the last of three, provides some insight into the case for higher earnings in Europe, and what this means for investors.
Encouraging signs of earnings growth
Europe has lagged the US and UK in terms of earnings growth recovery since the financial crisis and, for the last six years, European corporate earnings have failed to live up to high initial expectations. 2017, however, marks a change of tide. For all three quarters of the year so far, European markets have matched or exceeded earnings growth expectations and investors have been rewarded, despite the drag of a stronger euro on European exporters.
With the growth in earnings looking positive for the year so far (see chart 1), are we seeing the start of a more tangible shift in earnings growth and could this provide the foundations for valuations on European equities to move higher in 2018?
Chart 1: Earnings growth returns to Europe
Trajectory of consensus year-end earnings per share (EPS) growth (%) forecasts for MSCI Europe (YoY growth %). Source: Barclays Research, Datastream, MSCI, IBES as at 27 September 2017.
Signs that long-overdue earnings growth is finally making its way back into the system should help to boost confidence in the prospects of European equities. Europe’s recovery has started from a low base and consequently, earnings growth still has much further left to run. This adds to the possibility that Europe might more easily be able to deliver on the high forecasted earnings growth, on a relative basis, when compared to forecasts for the US and Asia.
Equity dividends provide better income than bonds
In the past, equity markets have struggled to compete with the high yields produced in bond markets but more recently European equities have come out on top.
Chart 2 shows that current European dividend yields excel against other income competitors. Today’s European dividend yield provides a much more attractive income opportunity than current bond yields across Europe on both an absolute and relative basis. Yields on European equities are currently eight times that of the German 10-year bund and well above those available on US equities. In a world of persistently low growth, where income is at a premium, European equities continue to offer a relatively high level of income for investors.
Chart 2: European dividend yields remain attractive
Source: Current European and US dividend yield and bond yields compared to their 30-year average. Janus Henderson, Thomson Reuters Datastream, 1 December 1987 to 1 December 2017. ‘Europe’ is the FTSE World Europe Index; ‘US’ is the S&P 500 Index; ‘AAA Corporate bond’ is the ICE BofAML AAA Euro Corporate Index (yield to maturity); ‘BBB corporate bond’ is the ICE BofAML BBB Euro Corporate Index (yield to maturity).
Implications of interest rate rise
As part of any discussion about Europe, we must consider the implications of the European Central Bank’s (ECB’s) recent announcement confirming a slow and steady normalisation of monetary policy, with a likely hike in interest rates in September 2018. As interest rates start to rise, this may cause a shift in leadership in markets as investors consider the potential consequences for companies that have burdened themselves with too much debt. Nonetheless, the slow and careful unwinding of quantitative easing should help to limit the impact of any uncertainty around monetary policy.
Investors have come to expect disappointments when it comes to European earnings, but unlike previous years, it seems that expectations for 2017 have largely been met or exceeded. The question, as we move towards 2018, is whether this momentum can continue. Forecasts for earnings growth look promising across most sectors in 2018 and any unwinding in recent euro strength could also provide a tailwind. Risks, of course, remain with the political situation as ever being capable of unsettling markets and monetary policy mistakes globally also adding to this. There will be winners and losers in Europe, with gaps between those companies that are able to deliver earnings growth and those that fall short, but with a selective approach it should be possible to identify beneficiaries during a sustained period of earnings improvement.
Earnings growth: The percentage change in net income over a period, as compared with the previous period. This is often used as a key indicator for measuring a company’s success.
Earnings per share: The portion of a company’s profit attributable to each share in the company. It is a commonly used way for investors to assess a company’s profitability.
Dividend yield: A dividend is a variable payment made by a company to its shareholders, and is paid as a portion of the company’s profits. The dividend yield is the dividend amount expressed as a percentage of a current share price.
Corporate bond yield: A bond issued by a company. Corporate bond yield is the amount of return an investor realises on the bond.
AAA and BBB rated bond: AAA and BBB represent ‘grades’ of bond credit quality for corporate and government bonds. These grades are determined by bond rating agencies. AAA represents the highest bond grade while BBB is usually the eighth highest grade, depending on the agency. AAA is associated with high levels credit worthiness, and both are marked as ‘investment grade’ meaning that it is likely to be a safe investment.
German 10-year bund: A bund is a debt security issued by the German federal government. A 10-year bund means that the bund will take 10 years to mature, in which time a fixed amount is paid to the owner of the security.
US 10-year bond: A US bond is a debt security issued by the US Government. A 10-year bond means that the bond will take 10 years to mature, in which time a fixed amount is paid to the owner of the security.
German 3-month FIBOR: The Frankfurt Inter Bank Offer Rate, or FIBOR, is a benchmark rate used to determine interest rates for a borrowing period of three months for banks in Germany.
US 3-month rates: A benchmark rate used to determine interest rates for a borrowing period of three months for banks in the US.
Quantitative easing: A measure whereby a central bank creates large sums of money to purchase government bonds or other securities, in order to stimulate the economy.