Marginal differences: Can Europe catch up with the US?
US margins have been the success story of this cycle; the gap with Europe is now 300bp, higher
than at most points in the last 20 years. However, US margins have been boosted by tech stocks,
whereas in Europe resources stocks have had a greater drag on profits. Indeed, if we sector-weight
the margins of Europe by US weights, we find the gap (while still present) is no bigger than on
average. We still see earnings upside for Europe, driven by GDP growth and a weak euro; we
expect high single-digit growth in 2016/17. But catch-up with the US is likely to prove elusive.
* US earnings have outperformed because of margins
Since the financial crisis, US earnings have recovered to over 30% above
their previous highs. Meanwhile, European earnings – after initial recovery
in 2010/11 – have flatlined and remain below the 2007 peak.
* US net income margins 300bp above Europe
Sales performance has lagged in Europe, but the chief difference is
margins. US net income margins are close to peaks and c.300bp above
Europe. This gap is high versus history; it has only been exceeded during
the sovereign crisis in 2012/13 and in the post tech bubble collapse in
2003/04, which hit Europe more.
* Disappearing gap: When you remove tech, the gap is at average
We think there is potential for a small narrowing of the gap between the
US and Europe, but we are doubtful that margin improvement will be a big
driver of profits in Europe over the next two years. The gap with the US is
somewhat an illusion, in our view; once we adjust for differing sector
weights and, in particular, take out tech, the difference is reduced and the
gap between the US and Europe is no longer different to the long-term
average margin differential.
* So if there is no catch-up story, is there no earnings story?
We are not that sceptical; we see good reasons to expect at least high
single-digit earnings growth in 2016 and 2017, forecasting 8% and 10%,
respectively. This type of growth, combined with continued easy monetary
policy and reasonable income (DY of 3.4% in Europe), should continue to
be an attractive combination for investors. Ex-commodity sectors, we
expect earnings growth in 2015 to be (a healthy) 8-10%. In 2016, our
economists forecast reasonable growth in Europe, stabilisation in most
EMs and a weaker euro; these should all support earnings. And, by 2017,
resources stocks could also be seeing improvement.