House View: Q2 2017

  • Q4 earnings were the strongest in two years for developed markets
  • Earnings revisions also showing positive momentum
  • Reflation trade that dominated markets last year has struggled this year
  • Valuations in Europe remain more attractive relative to the US, but heightened political risk remains a concern

Summary

Earnings momentum continues to grow across developed markets (US, Europe and Japan), with all regions posting impressive year-over-year growth in Q4. Looking ahead, we have also seen a positive trajectory for earnings revisions which should bode well for this upward earnings trend to continue. From a valuation perspective, Europe would appear more attractive than the US, though we would caveat this with the political uncertainty of upcoming elections in a number of European countries this year (France and Germany) which may mean that some investors remain on the sidelines.

2017 has so far seen a cooling off of the reflation trade that dominated equity markets in the latter half of 2016, with more defensive sectors such as consumer staples and healthcare performing relatively well. Energy has been the main laggard so far year-to-date, as markets question the sustainability of the announced OPEC cuts to production and data indicates crude inventories continue to build in the US.

Earnings season strong across developed markets

With the majority of companies having reported Q4 results across the US, Europe and Japan, the main takeaway is that we have seen a continuation of the upward trend in earnings that we saw in the previous quarter (Figures 1-3). Europe and Japan in particular posted impressive double-digit growth year-over-year; indeed this is the first time in six quarters that European and Japanese earnings growth has exceeded that for US companies. Earnings revisions ratios (the ratio of analysts’ upgrading their earnings forecasts relative to those downgrading) are also looking stronger in Japan and Europe, where we are actually seeing net upgrades. It’s worth noting we are also seeing an improvement in earnings revisions, with 2017 growth expectations being revised higher compared to where they were at the start of the year.

European equity valuations vs US

European equities have materially underperformed US equities for an extended period, now stretching to 2008. In total US companies have outperformed their European peers by nearly 100% in USD terms. A large proportion of this outperformance can be explained by the much stronger earnings backdrop in the US – looking at forward EPS (earnings per share), the US has recovered much faster from the prior recession, with European company earnings having virtually stagnated over the past six years (Figure 4).

In terms of profit margins, we’ve also seen a large gap open up between the two regions, with European companies substantially less profitable than their US counterparts (Figure 5). The issue here appears to be less about costs and more about pricing power. The relatively weak demand environment combined with deflationary pressures has meant European corporates have faced a significant squeeze on their ability to push through price increases. We are seeing some signs of improvement here, with the demand outlook improving and inflation coming back into the Eurozone economy – indeed companies such as Schneider Electric (one of the large European industrial players) have pointed towards a better pricing environment of late. Even a relatively small uplift in margins combined with further top-line growth would be enough to drive a meaningful acceleration in earnings.

Contrast this with the US, where there are some signs that margins are getting squeezed, with rising wage costs starting to have an impact – whilst we expect demand to remain robust, there does seem to be more opportunity for European companies to boost margins than for those in the US.

Given the positive earnings momentum and the current valuation discount, one might rightly question why we have not been seeing more positive flows into European stocks. When analysing the cumulative weekly flows into a range of regional mutual funds and ETFs, European flows have largely been flat since the start of the year – political uncertainty seems to be the primary reason for investors staying on the sidelines, with upcoming elections in the France and Germany leaving many reluctant to allocate any significant new capital. The US, by contrast, has seen continued inflows, albeit not at the aggressive pace we saw in the immediate aftermath of the Trump election victory. 

Reflation trade cooling off?

One of the major drivers of equity markets during 2016 was the so-called “reflation trade” as investors rotated into cyclical sectors that they felt would benefit more from increased inflation and growth expectations and away from higher quality defensive stocks. This can be seen in Figure 6, which shows the relative performance of European and US cyclicals vs defensives. The Trump election victory accelerated the rotation that had begun in July last year, though year-to-date the momentum has somewhat stalled, with sectors such as consumer staples and healthcare actually outperforming the broader market. The energy sector has been the main negative drag, with recent data indicating crude inventory levels have been building in the US and some doubts over whether the announced cuts to production from OPEC will be maintained. 

Conclusion

The strong earnings momentum we are seeing across developed markets should be seen as a positive for equities – this combined with an improving macro outlook should provide support to markets, although valuations are already reflecting this positive tone to a large extent. From a valuation perspective Europe provides an interesting opportunity set for global investors over the longer term, provided they are willing to absorb some of the political risks that will likely dominate headlines over the coming months.

 

Note: Investment professionals listed are members of AIA/AIC's participating affiliate Aviva Investors Global Services Limited ("AIGSL"). 

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