Keep a stout heart

There were three defining themes to the first-quarter European earnings season: the weaker euro, the low oil price and the relative strength of the economic environment.

However, renewed optimism for the region has led many investors to adopt a cautious approach to the region – perhaps rightly so, given that valuations are sitting at a decade high on a forward price-to-earnings metric. This implies the need for continued strong earnings growth and a selective approach to investing.

Financials recorded some of the strongest earnings growth and are benefiting from the region’s economic rebound. But investors have not favoured financial stocks and view the banking sector in particular with a healthy degree of scepticism given worries over non-performing loans and the transparency of financial accounts.

However, despite this robust earnings growth, financials are the only part of the equity market not to have recovered the losses since the financial crisis, remaining below their previous market peak set in October 2007 on a total return basis.

But as the economic recovery continues to take hold and credit conditions improve, this should provide a supportive backdrop for profitability through increased lending activity. The risk is that ECB bond purchases pull down the long end of the yield curve and cut into bank profitability by lowering net interest margins.

The weaker euro helps those companies within the single currency bloc, but is proving to be a hindrance to those outside it.While the euro has depreciated by 15.0 per cent over the past year on a trade-weighted basis, the Swiss franc and the UK pound have appreciated by 11.8 per cent and 4.5 per cent, respectively, hindering exporters’ revenues.

Germany, with its strong export orientation, has probably benefited the most from the euro’s slide, since this has helped offset the impact of slowing demand in China, one of its biggest export markets.

Over the past 12 months, a healthy overweight towards export-orientated companies will have worked well for investors. As shown in the chart above, those companies that generate the bulk of their sales from outside the region have outperformed.

While the benefit of a lower euro will linger in year-on-year earnings comparisons for a while longer, its overall impact will fade, and investors should not rely on a further leg down in the currency to support earnings. For this reason, investors should keep an eye on the long-term horizon and factor in a cyclical tilt in European equities that should benefit from the ongoing domestic recovery.

Higher-frequency economic data from the eurozone has been below consensus estimates in recent weeks, but the data remains exceptionally strong by historical standards. There is evidence of improving credit conditions within the eurozone and the growth in money supply suggests that economic data, such as the key purchasing managers’ index surveys, can rebound. We therefore expect the economic backdrop to remain robust and see further upside in cyclical sectors.

It is unlikely that European equity markets will be able to maintain the momentum seen so far this year and record another 15 per cent gain through the end of 2015. Because of this, investors should moderate performance expectations. However, stronger earnings growth and generous dividend yields of more than 3 per cent suggest that decent returns from current levels are possible, justifying maintaining an overweight to European equities.

It is unlikely that European equity markets will be able to maintain the momentum seen so far this year

The pace of the rally in European equity markets has caused investors to become more cautious towards the region as valuations begin to look extended. Investor confidence in the region now needs to be translated into genuine earnings improvements to justify current levels.

The impact of a lower euro and oil price will continue to provide a near-term boost to earnings, but sustained earnings growth will need to be about more than quantitative easing or the currency. The improvement in the credit cycle is an encouraging sign of longer-term economic growth, which should benefit the cyclical areas of the equity market. But the higher level of European stocks highlights the need for selectivity and a focus on the fundamentals.

Kerry Craig is global market strategist of JP Morgan Asset Management