Higher real bond yields mean lower P/Es
•The European Q3 earnings season has been weak: with 80% of companies having reported, only 48% of companies have managed to beat earnings estimates, compared to a long-term average of 55%. What is more, Q3/Q3 earnings are down by a staggering 43%, the largest year-on-year drop since Q4 2011. However, losses are concentrated in only a few sectors and appear mostly due to idiosyncratic factors: (a) energy names account for 45% of the fall in earnings; (b) a further quarter of the losses is accounted for by write-downs and provisions taken by two large German large corporates; (c) three large Swedish investment funds account for around 20% of Q3 losses, driven by a 16% correction of the Swedish equity market in Q3. While a further fall in the oil price might translate into additional downside for energy earnings, we would regard most of the other drivers of the weak Q3 season as one-offs – and, hence, stick to our EPS growth target of 3% for 2015 and 9% for 2016.
•European banks have seen solid EPS growth in Q3 – and are positioned for further upside. Despite the negative commentary around the sector, banks has continued to be among the sectors with the strongest year-on-year income growth at 12%. As a consequence, the sector’s relative 12-month forward RoE has risen to a seven-year high. This is consistent with a P/B discount to the market of around 40%, pointing to upside from the current 50% P/B discount.
•We are cautious on UK equities, in spite of our FX strategists’ bearish GBP call: our strategists expect sterling to fall to £/$1.27 by the end of 2016, given last week’s dovish Inflation Report, stretched valuations, more fiscal tightening to come and the large current account deficit (see their report Turn bearish GBP, Nov 5). A weaker GBP should help UK equities, given that 65% of revenues come from outside the UK and a 10% fall in sterling boosts EPS growth by around 14 percentage points, according to our model. Yet, we are still cautious on UK equities, given that: (a) we don’t think the case for GBP weakness is clear-cut (given wage growth at 3.2%, compared to 2.5% in the US); (b) the UK market still has a high commodity weighting (15% of market cap, versus 8% for Europe ex UK); (c) valuations are still not compelling: relative Shiller P/Es are only in line with the historical average, and while the P/B relative is at a 15-year low, this is not the case if we exclude resources. For investors wanting exposure to the theme of sterling weakness, our screen shows cheap UK exporters with a DB buy-rating (AstraZeneca, Smith & Nephew, EasyJet among others).