Goldman Sachs Global Macro Research
Strategy Espresso : Lower growth, inflation, and Euro: What this means for our view on European equities
Revising down our earnings forecast
Following the downgrade to our Euro area GDP forecasts (see European Views: Forecast update: Incorporating downside news to activity and inflation, October 3, 2014) we revise down our earnings estimates. While the European market offers international exposure, close to half of revenue is still derived from the Euro area and therefore this downgrade takes down the aggregated level of growth to which European companies are exposed. The table below highlights, based on our forecasts, the growth in each region as well as the aggregate based on sales exposure. The downgrade to overall growth for 2015 is about 30 bp.
As a result of this lower growth environment, we revise down our estimate of earnings growth for this year to 5% (from 6%) and for next year to 8% (from 12%). We leave unchanged our 2016 and 2017 growth estimates. This downgrade is in-line with our estimated sensitivity of earnings to GDP growth of about 10x (see GOAL Strategy Paper No 12: Profit Pathology, April 4, 2014). These numbers are below I/B/E/S consensus growth of 6% for this year and 14% for next year. Overall, we are 6% below consensus estimates on end-2015 numbers and therefore expect a continuation of negative, but small, earnings revisions at the market level.
The table below details our sales and earnings forecasts. Three points are worth highlighting
* We continue to forecast a low and slow earnings recovery with growth below 10% in the next three years. This is unusual after a recession as earnings tend to expand rapidly as margins recover. This is driven by a combination of low economic recovery for the Euro area and a reasonably high starting level for net income margins.
* For the next few years we have over half of non-financials earnings growth coming from top-line growth rather than margins which is unusual at that point in the economic cycle. This is driven by a combination of limited acceleration in economic growth (which implies only small operating leverage) and a lower Euro which tends to be more favourable to sales than earnings.
* As a result, our EPS forecast for 2017 is still below the level reached in 2007, the previous peak, pointing to close to a lost decade for European profit even in nominal terms. The margin is also substantially below the 2007 level.
In terms of sector breakdown, we continue to expect higher growth in financials than non-financials given the depressed level of earnings for the banks sector and ongoing normalization in loan loss provision. More precisely, we expect financials earnings growth to be close to half of overall earnings growth for the market (44%). While financials help lift the overall earnings growth for the market, it also highlights some vulnerability of our earnings outlook given the large negative revisions we have seen in financials earnings over the last three years.
Lower targets but still good returns
Considering our new earnings numbers, we lower our targets for the STOXX Europe 600 index to 345, 355 and 375 for 3, 6 and 12 months respectively (compared to 365, 375 and 390 previously). Our revised targets point to a price return of about 13% from the current level and a small expansion in the forward multiple from 13.5x currently to 14.7x in 12 months' time. This is driven by a moderation in the equity risk premium which is only partially offset by a rising, but still low, bond yield.
On these numbers, the pan-European market would be 6% below its 2007 peak and 20% below its peak in USD (taking into account our 1.20 12-month EUR/$ forecasts). This offers a stark contrast with the US where the S&P 500 is 25% above the 2007 level.
We also update our forecasts for the FTSE 100 and the Eurostoxx 50. We expect small outperformance of Eurostoxx 50 and small underperformance of FTSE 100. The table below summarizes our new forecasts.
In light of the economic changes we have also made some changes to our thematic and sector views:
What we are changing:
* Take off our long recommendation on the DAX; the German market is inexpensive and operationally geared to rising economic growth, also the index overall is a commodity-consumer and should benefit from falling oil and metals prices and from the weaker Euro given its dependence on exports. But the weakness in growth momentum and inflation is more than offsetting this and the index is down 4.2% versus the market since we initiated a long in September 2013. Furthermore, our Economists' downgrades to German growth have been deeper than for the rest of Europe with sequential growth only returning to 0.4% in the middle of 2015 on their new estimates.
* Remove our long on the DM growth basket (GSSTDMGR): this is up 2.0% versus the market since we recommended it in July 2013. The performance was strong until March of this year; since then the weaker demand profile, especially in Europe, and the lack of other catalysts (further narrowing of spreads in Europe) has pushed performance down. We would look to re-enter this trade when growth momentum shows signs of turning. The basket trades on 11.7x forward earnings, a 12% discount to the market. However on current analyst estimates it trades on twice the average EPS growth in 2015.
* We take off some of our sub-sector basket recommendations: We remove our long recommendation on Staffers (GSSBSTAF) given their gearing to European domestic growth; we also remove our long Luxury goods vs. short Food producers recommendation. Downgrades to EM growth and geo-political concerns are likely to weigh on the luxury companies.
What we are keeping:
* Structural underweights in sectors with EM industrial exposure. We remain Underweight Basic Resources where we think a combination of reduced global demand growth and excess supply in most metals will continue to push down metals prices and negatively impact earnings, cash flows and ultimately the ability to pay dividends. We remain Underweight Oil Services where again we see a lack of capex spending by the oil majors and falling oil prices as ongoing negatives to earnings.
* We remain Underweight Retail and Telecoms which we see as structurally challenged; both suffer from a deflationary environment and a lack of obvious ways out for the incumbent players.
* Strong UK domestic growth combined with unusually mild inflation; we continue to like the FTSE 250 vs. FTSE 100. The FTSE 100 is more exposed to weaker growth in EM and some of the structural problems mentioned above. Also the UK economy is one of the few where we remain confident in our strong growth forecasts, inflationary pressures also remain subdued with sub-par wage growth and falling commodity prices. We think the MPC will raise rates in early 2015 but our Economists foresee a shallow profile for rate increases. Against this favourable macro backdrop, the FTSE 250 is only at a 10% premium to the FTSE 100. On this basis we also continue to like the UK Homebuilders which benefit from both healthy supply dynamics in housing and more recently have started returning capital to shareholders.
* Exposure to greater easing by the ECB; we remain Overweight Banks: support from the ECB by expanding its balance sheet and offering continued cheap liquidity to banks, as well as structural changes which should benefit the sector as the ECB takes over as single supervisor, are ongoing supports in our view. In addition we retain our long on the Financial Leverage basket (GSSTFNLV): this basket should benefit as financial conditions ease and provided that growth in Europe does not turn outright negative.
* Companies with a high yield combined with secure balance sheets and the ability to grow dividends should also remain an attractive combination for investors - arguably even more so in a lower growth environment in which bonds yields have again been pushed down. Companies continue to have excess cash on their balance sheets, making this slowdown in growth somewhat unique relative to previous cycles and we believe paying dividends is one of the key ways in which cash will be used - indeed with growth rates slowing slightly one could argue this case even more strongly. We continue to recommend our high DY Plus Growth basket (GSSTHIDY).