This time last year, the Invesco International and Global Growth team was optimistic about the better relative earnings potential that we saw building in Europe. Indeed, the trends played out to our benefit over the course of 2017.
In U.S. dollar terms, European equities outperformed U.S. equities by 3% in 2017, the first time since 2012.1 Europe’s performance was supported by healthy earnings per share (EPS) growth. Companies are scheduled to release their fourth-quarter figures over the next few weeks, and consensus estimates expect 2017 EPS growth to be in the double-digits – a level that has not been seen since 2010.1
During the last three months of 2017, Invesco International Growth Class increased its exposure to eurozone and U.K. equities, after being net sellers in Europe through the first nine months of the year. To understand the bottom-up stock opportunities we’re seeing, it’s critical to examine the fundamentals of European corporations using our Earnings, Quality and Valuation (EQV) philosophy.
- Global economic momentum looks positive, with lead economic indicators and gross domestic product currently rising around the world. We believe that the current strength in activity is unlikely to abate quickly, supporting the earnings outlook as we roll into 2018
- Eurozone growth is expected to outpace U.K. growth, but we believe both areas should see revenue and earnings growth supported by above-trend global growth (more than 3%) and good operating leverage
- Notwithstanding the margin improvements seen in 2016 and 2017, European margins have only reclaimed about half of their decline from 2010 to 2015.2 That suggests continued scope for positive margin surprises in many European corporations (including many of our holdings)
- Consensus expectations are for European earnings to grow in the high single digits in 2018, following what looks like double-digit earnings growth in 2017. The scope for even better operational leverage would be a wildcard to the upside
Bottom line on earnings: Momentum may moderate from here, but activity is likely to remain firm, with the scope for European corporate earnings to benefit from further operating leverage.
- European returns on capital improved in 2017. We expect continued improvement in 2018, aided by better revenues on a large fixed-cost base as well as measured capital expenditures
- Eurozone corporate financial leverage has remained modest compared with the leverage of U.S. corporations. This provides greater scope for European companies to releverage their balance sheets, potentially delivering greater financial gearing to earnings per share
Bottom line on quality: European corporations have enjoyed positive incremental returns on capital, and they have greater options for releveraging their balance sheets.
- European valuations are by no means cheap. At the end of December, the MSCI Europe Index’s 12-month forward price-to-earnings (P/E) ratio stood at 14.9x, about 20% above its 10-year average of 12.3x.2
- However, it’s important to remember that Europe’s 12-month forward P/E represents a 20% discount to the U.S., marks a five-year low, and is close to a full standard deviation below the long-term average2
- Furthermore, if you exclude financials and technology, the P/E in Europe is close to a decade low versus the U.S.2
- Yet, stronger scope for better margins exists in Europe versus the U.S.
Bottom line on valuations: European valuations are not cheap, but they are more attractive relative to the U.S., and they are supported by better relative operational and financial gearing potential.
Key risks/events on horizon
- U.K. growth uncertainty. Ongoing Brexit negotiations continue to cloud our visibility into the region’s growth prospects. In the meantime, the Bank of England’s (BOE) willingness to tighten interest rates in order to ward off currency-inspired inflation is problematic. Both Brexit and BOE policy raise the risk premia required on U.K. equities, all else equal. In areas where we believe this provides good long-term value, we will be active
- Wage inflation. If wage inflation were to come in higher than expected, it could lead to higher nominal interest rates and faster-than-expected central bank tightening. It seems too early to worry about this in Europe, outside of perhaps Germany, but it is worth watching wage inflation closely
- Italian elections. Polls show that the Italian electorate has the highest percentage of voters holding a negative view of the euro. If history is any guide, a coalition-led government is expected to once again prevail in the general election in March, thus limiting the threat of an anti-euro outcome
- Catalonia independence movement. Separatists failed to get 70 votes in December’s parliamentary election, but 68 votes are meaningful and will likely continue to foment political unrest in Spain
Three new holdings initiated in Europe
As mentioned above, we increased our exposure to eurozone and U.K. equities in the fourth quarter of 2017. That included three new European initiations:
- Reckitt Benckiser Group PLC (1.28% of the Fund as of Dec. 31, 2017). This company is a leading producer of consumer health, hygiene and home care products. Its shares de-rated on organic growth concerns, but those concerns look to have been short-term in nature, versus the longer-term structural growth drivers for the category.
- Mediobanca SPA (0.73% of the Fund as of Dec. 31, 2017). Italy’s leading investment banking franchise, Mediobanca is using its strong balance sheet capacity and strong advisory brand credentials to move into the more stable/higher return on equity wealth management arena.
- Vivendi SA (0.25% of the Fund as at Dec. 31, 2017). Through its Universal Music Group division, Vivendi is the world’s largest owner of recorded music content and provides exposure to the fast-growing, recurring revenue associated with the secular shift toward paid music-streaming subscriptions.