European equity markets have started the year strongly, outperforming US markets. Markets across Europe have risen steadily in anticipation of further action from the European Central Bank.
Now that the ECB has delivered the goods on its well-received programme of sovereign bond-buying, there is an expectation that its asset purchases will continue to drive markets higher. However, simply applying the experience of US quantitative easing to Europe is dangerous. Investors should focus instead on the fundamentals and the ability of companies to deliver earnings growth over the rest of the year.
Enthusiasm for European equities in recent times has largely been driven by multiple expansion and confidence that the actions of the ECB would restore growth in the single currency bloc. This confidence has meant that investors were willing to pay more for future corporate profits, which never actually materialised, and the rise in earnings has lagged behind the market.
All this changed in the third quarter of last year, as the long-awaited earnings growth started to appear. It was early days, but the cyclical sectors started to produce positive earnings growth, and the pace of growth across the broader European stock market outpaced US equities.
The US earnings season is almost at an end, while the European season is just ramping up. The stronger US dollar and the fall in the oil price have caused many companies to miss forecasts, leading analysts to revise down their expectations for the full year. Market watchers are waiting to see if Europe can build on last quarter’s numbers and once again beat the US.
In Europe, a rising tide will not lift all boats. Some of those boats are leaking heavily and others should be sunk. Knowing which are seaworthy will be vital for investors keen to get back on the water in Europe.
Earnings growth in Europe has so far been driven by margin expansion, rather than top-line sales growth as companies cut costs to maintain earnings. This tactic can only work in the shorter term, and will fail as a strategy to generate long-run earnings growth. However, it does mean that there is very little fat on European companies, and even a small increase in top-line revenue will very quickly appear on the bottom line.
The lack of sales growth is unsurprising given sluggish domestic demand, weakness in emerging markets and the impact of sanctions against Russia. By the end of 2014, more than half of the companies in the broad European Stoxx 600 Index were domiciled in countries with inflation rates of less than 1 per cent, and a quarter were based in countries with outright deflation.
After a couple of years of sub-standard growth, 2015 could be a much better year, especially if the old adage “as goes January, so goes the rest of the year” proves to be true. A number of analysts are forecasting total returns of over 20 per cent for European markets this year, which seems a little on the high side. Valuations are less attractive than a few years ago and the growth outlook has improved. However, it will remain lacklustre for some time, and inflation is only likely to get back above zero near the end of the year. Double-digit returns may be achievable, although getting above 20 per cent may be challenging without a large shift in valuations or a significant surprise in earnings growth.
A weaker euro will be a big boost for the market as 45 per cent of revenues come from outside the region. It also tends to lead to stronger relative earnings performance of European companies as against their US peers over subsequent quarters.
There are two further reasons to believe that the eurozone will experience stronger growth in the year ahead, benefitting the region’s equity markets. Strengthening credit markets and lower oil prices both provide a steady tailwind. However, with valuations no longer cheap, looking beyond the index is critical. Cyclical sectors will benefit from any pick-up in economic growth and the financial sector may benefit from the improving credit climate.
But as with all rewards, there are also risks. Deflationary pressures will persist for certain sectors, while the ongoing political risk from Greece is likely to make its unwelcome presence felt for some time to come, and could influence elections in Spain later this year. All these factors are likely to create further volatility across financial markets this year.
Kerry Craig is global market strategist of JP Morgan Asset Management
