European Stocks Could Outperform This Earnings Season

 | Oct 11, 2017 | 9:00 AM EDT
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Earnings season is almost upon us, and it may bring some positive surprises for investors in European stocks. Investors have been disappointed time and again by the profits of companies in Europe, but this time the signs are pointing toward a good scenario for earnings.

Global economic growth of 3.2% last year was the weakest since the financial crisis, according to the International Monetary Fund (IMF). For this year, however, the IMF projects growth to rise to 3.6% and for next year it sees it at 3.7%. The eurozone, together with Japan and Canada, will lead the rebound in advanced economies, in line with their stronger-than-expected momentum in the first half of the year.

The IMF's view is in line with the views of other economists. Oxford Economics, a U.K.-based think tank, says the world is going through "a synchronized Goldilocks" environment of strong growth with relatively muted inflation. This is led by a strong rebound in manufacturing, driven by Europe.

"This environment is fundamentally conducive to outperformance by assets leveraged to global growth. Equity earnings cycles, especially in underperforming markets in Europe and emerging markets, should continue to power ahead," Gaurav Saroliya, director of global macro strategy at Oxford Economics, wrote in recent research.

Since the eurozone debt crisis erupted in 2011, all major equity markets underperformed Wall Street in U.S. dollar terms, but most have had better cumulative earnings performance, according to Saroliya. He does not expect monetary policy normalization to be "disruptive" to risk assets because its pace will be subdued, and if yields rise it will happen because the world economy gets stronger, Saroliya maintains.

The positive outlook for earnings is supported by the resurgence of "animal spirits" in Europe, where capital expenditures, mergers and acquisitions and cash returns all have picked up, according to equity strategists at Bank of America Merrill Lynch. European companies increased their capital expenditures by around 2.6% in 2017, the first time in five years that capex has grown.

Adding to these positive expectations is the belief that the European Central Bank (ECB) is likely to move exceptionally slowly when it comes to raising interest rates, as President Mario Draghi keeps reassuring investors.

European valuations look reasonable, argue Bank of America Merrill Lynch strategists Ronan Carr and James Barty. The price-to-earnings (P/E) multiple on the STOXX Europe 600, at around 15, trades just a little above its long-run average of 14. Europe trades in line with its average since 2015 while equity yields still look "very inexpensive" relative to fixed-income yields, the strategists note.

European companies' profit margins have stagnated for five years but have rebounded by 70 basis points over the past 12 months, and free cash flow (operating cash flow minus capital expenditures) is recovering, the strategists add.

In terms of sectors, they prefer the long-suffering European banks, saying that the sector is "effectively long a call option on any earlier-than-expected rate normalization in Europe." They estimate that a move of the ECB's deposit rate to zero from a negative 0.4 would boost the sector's profits by 25% over time. They are also overweight other two cyclical sectors, namely construction and chemicals.

We are talking about Europe, so the risks are always there. But, as Catalonia's recent return from the brink shows, the Europeans are masters at finding ways to muddle through their disputes. Risks often prove to be buying opportunities.

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