Back to School: China, US Rates and Earnings…
Q.1: Is the European profit recovery still intact?
After the holiday period, we look at 4 key questions for European equities. Recent
market moves and growth scares have raised questions over earnings. Still we see the
profit cycle intact supported by: (1) the first top-line growth (ex-commodities) since
2012, (2) the Euro is still a tailwind (TWI currently down 8% YoY), (3) operational
leverage is starting to kick in, and (4) the Banks make up over 100% of the market’s
2015E EPS growth and over one-fifth of 2016E. Q2 earnings were one of the best
beats in 5 years and in August, despite the correction, there were net earnings
upgrades in the Eurozone.
Q.2: What are European Equites now pricing in?
After the 15% fall since mid-April are European Equities now cheap? Not obviously so –
the P/E has fallen back to 14.1x, in line with the long run average. But this is on very
depressed earnings. We need to adjust valuations for the stage of the cycle: both Trend
earnings and CAPE suggest European equities are c.20% cheap. If we simply look at
forward P/Es, the European equity market appears more expensive now than it was at
the peak in June 2007 – not something we believe to be the case.
Q.3: What are the risks between now and year-end? (China, US rates, Greece…)
The key question is: "Does the slowdown in China and EM derail the US and European
recovery?" We think not. But we foresee continued weakness for China exposed stocks
as earnings downgrades accelerate. We think the first US rate hike (when it comes) will
have relatively limited impact on European equities given it has been well telegraphed,
the US cycle and Europe have decoupled and we are starting from extremely low levels.
Q.4: What to buy within the market? (Domestic stocks, Banks and Cyclicals)
We focus on domestic cyclicals: the macro momentum in Europe is better than in many
overseas markets and European companies with high domestic exposure are seeing
earnings upgrades. We overweight Banks and Cyclicals. Countries: most preferred =
Italy, Spain, Portugal and France.