Developed markets equity: Earnings and M&A driving markets forward
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- Q1 earnings were the best in nearly seven years for developed markets
- All major regions delivered double-digit earnings growth
- Earnings recovery has been broad-based across sectors
- M&A activity remains strong, although risks remain to deals completing
The recent Q1 earnings season has seen a continuation of the uptrend we have seen from the prior two quarters. All developed markets posted double-digit yearover-year gains, reflecting the best growth we have seen in nearly seven years. Japan was the standout performer, with Europe and the US also posting solid gains. Importantly the earnings momentum was fairly broad-based across sectors, and also was accompanied by impressive revenue growth on the top-line. The quarter also saw notable M&A activity, with US companies continuing to focus their attention on cross-border transactions with Europe in particular.
Earnings continue to power ahead - Europe and Japan leading the way
The past quarter has seen a continuation of the upwards earnings momentum in developed markets, with all major regions posting impressive gains. Japan reported year-on-year EPS growth of 28 per cent, with Europe coming in at 23 per cent and the US at 14 per cent (Figure 1, Figure 2 & Figure 3). Overall this would be the strongest quarter of growth in nearly seven years; encouragingly top-line numbers were also healthy, with 10 per cent sales growth in Europe, just ahead of the other regions. There was also fairly broad-based strength across sectors, with 10 of 11 sectors recording positive growth in both Europe and the US. We have seen a significant rebound in earnings since the second quarter of last year (Figure 4), and expectations are for this to continue in the next quarter, albeit at a more moderate pace. For the majority of regions FY 2017 growth expectations remain ahead of where they were at the beginning of the year.
Reasons for optimism in Europe
In the previous quarterly view, we highlighted the valuation differentials that suggested reasons for potential outperformance of European equities vs their US counterparts. Clearly another important factor has been the resurgence in earnings for European companies, with the upward trajectory in earnings revisions also cause for optimism. In the last three months there have been significant upgrades for European companies, with only Japan seeing more upgrades relative to downgrades in terms of developed regions. Indeed EPS growth expectations for 2017 in Europe have been rising steadily for the past 8 months now, currently standing at 18.9 per cent. This is a marked contrast to the previous 5 years, where we have seen cumulative downgrades in the region of 10 per cent every year (Figure 5).
Leading indicators would also suggest that this momentum is sustainable; there is a relatively strong historic relationship between business surveys such as the ISM and PMIs and EPS growth (Figure 6). The recent bounce we have witnessed in both survey indicators should bode well in terms of achieving the elevated consensus expectations.
We have also started to see signs of margin expansion coming through - this has been one of the primary reasons European corporates had lagged their US counterparts since the global financial crisis. One of the main drivers for this has been the increase in inflation expectations which has helped provide some pricing power which had been largely absent in the prior deflationary cycle. Industries with higher operating leverage have also been benefitting from an improvement in top-line growth. From a flow perspective, we have seen recent inflows into European equities continue as the political risk has receded to some extent with the victory for Emmanuel Macron in the French presidential election bolstering investor confidence.
M&A in focus
M&A activity so far this year has remained healthy, with a number of deals announced across a range of sectors. Interestingly we have seen a number of proposed cross-border transactions, with US companies increasingly looking to acquire European counterparts. This reflects the positive corporate momentum we have been seeing in Europe, which combined with the valuation discount relative to US equities and increased political stability has spurred US corporates into action. With balance sheets remaining in healthy shape and interest rates near record lows we would expect activity to remain strong.
The one caveat for investors would be the associated risk with certain transactions - we have observed a number of high-profile proposed deals falling through this year. Kraft-Heinz’s failed bid for Unilever was the main example of this in the first quarter, and we saw US chemcials giant PPG finally pull out of its proposed bid for Dutch counterpart Akzo Nobel (after having three separate bids rejected) at the beginning of June. This in itself raised some governance issues, with many Akzo investors frustrated at the lack of engagement from the board of the company with PPG. Many other proposed deals also face regulatory scrutiny, with regulatory bodies under pressure to demonstrate the deals are in the best interests of consumers rather than the companies themselves.
There has been an ongoing debate of late regarding so-called ‘hard’ and ‘soft’ data points in developed markets. Whilst some of the ‘hard’ macro indicators have certainly lagged, from what has been observed in business surveys and sentiment indicators, from a corporate perspective, the ‘hard’ datapoint of earnings has given cause for optimism. The fact that we are seeing earnings revisions being upgraded (in contrast to prior years where we have seen sharp downgrades) should also provide some comfort that this momentum is sustainable. The improving corporate momentum can also be seen in the robust levels of M&A activity, with US companies increasingly shifting focus to overseas acquisitions. Investors should be wary though of proposed deals falling through, with regulators scrutinising deals ever more closely.
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