European Equities: Recovery Underway, Earnings to FollowDec 1, 2017

2018 Outlook: “A decade of extraordinary central bank policy support will begin to end in 2018, but a favorable economic environment and improving corporate fundamentals could allow European stocks to play further catch-up with US equities.”

Europe looks to have turned the corner. For the first time since the 2007–2009 global financial crisis, the European economy appears strong enough to stand on its own, no longer in need of massive central bank support. And with corporate profits still well below their previous peaks and valuations as of November 2017 looking fair given the more promising economic environment, European equities look to us to be potentially poised for another solid year in 2018.

Rising Economic Growth, Ebbing Political Worries

The global economic recovery became self-sustaining in 2017, in our estimation, and we anticipate growth both in Europe and around the world to remain healthy in 2018. A combination of factors are behind the brighter outlook for most European economies, including robust domestic consumption, an end to fiscal austerity and improving credit conditions. Inflation has remained low, but we expect an eventual pickup as the recovery progresses.

The United Kingdom has been an exception as domestic demand faltered in the wake of the 2016 Brexit vote. A weaker currency and the resulting rise in inflation have crimped consumers’ spending power. While we see some of this impact beginning to abate as the British pound regains its footing, the economic environment is likely to remain highly uncertain as fraught negotiations between the United Kingdom and European Union over Brexit continue throughout 2018.

Politics overall have ebbed as an issue for European markets, however. We anticipate an eventual easing of tensions in Spain over Catalonian independence and view a potential populist government following elections in Italy in 2018 as unlikely after recent changes to the electoral laws.

A Change in Policy

As the economic backdrop improves, global monetary policy is poised to enter new, uncharted territory. We will, for the first time since the financial crisis began, see all four major central banks start the slow process of turning monetary policy tighter, albeit to varying degrees.

The US Federal Reserve (Fed) has already begun this process, and after the rate hike from the Bank of England in early November 2017, Britain’s central bank is also on the path of a slightly less accommodative policy. The Bank of Japan, while still maintaining its massive balance sheet, has deemphasized quantitative easing (QE) in favor of targeting the yield curve. The European Central Bank (ECB) will begin a moderate withdrawal of stimulus in 2018. It plans to halve its bond purchases starting in January, while extending QE through September as stubbornly low inflation remains a concern.

We anticipate financial markets should be able to take these moves in stride. But since these changes have no historic precedent, we will be keen to keep a close eye out for any unexpected consequences of the Fed’s outright balance sheet reductions and the ECB’s more limited asset purchases. We are also watching the US economy, where any unexpected slowdown in growth or jump in longer-dated bond yields, given the more advanced tightening campaign, could have repercussions for the European economic outlook.

Markets Can Still Play Catch-Up

While markets adjust to a new monetary policy environment, the underlying fundamentals of corporate earnings and stock valuations look supportive for European stocks. Unlike the United States, where corporate profits have already surpassed their pre-financial crisis peaks, European corporate earnings have lagged. According to data from FactSet, earnings at European companies were just over half of their prior peaks as of September 30, 2017, providing ample room for catch-up. As inflation begins to rise, we anticipate earnings per share, particularly among the more cyclical areas of the market, would likely follow suit over the next few years. We also would anticipate the oil and financials sectors helping to drive earnings growth. Depressed earnings at oil companies should benefit from a rebound in crude oil prices, while slightly higher interest rates can have a positive impact on bank earnings.

Euroland Sales and Growth Have Recovered, but Earnings Haven’t

February 2007–August 2017

European EPS (LHS, Rebased)

European Sales (LHS)

Euro Area Real GDP (RHS, Rebased)

Source: Barclays Research, Thomson Reuters Datastream, Eurostat, IBES. Euro area real GDP as of May 2017. Data as of 8/31/17.

European equity valuations as of November 2017 also looked attractive to us relative to those of the United States, but they were not necessarily cheap in a historical context. Our analysis suggests price-to-earnings ratios in Europe indicate that the market has been pricing in improving economic and earnings growth, but has not become euphoric. Furthermore, the current bull market in Europe has been more broad-based than in other regions, which we take as a good sign for the sustainability of the market’s potential.

It also suggests to us that trying to take advantage of short-term trading patterns may not be terribly effective in the current environment. Over the past decade, markets have largely focused on the short term at the expense of the medium- and longer-term view, in our opinion. We believe that this type of market opened up opportunities for contrarians willing to ride out the short-term volatility. We continue to see opportunities in Europe, but with the market have moved broadly higher and valuations looking fair, in our view, stockpicking is likely to become ever more important in 2018.