Much has been made of the weakness of the euro and the recent problems in addressing peripheral countries’ debt problems have revealed fault lines in the single currency. However, we firmly believe the euro will survive its current stresses, even though a period of further weakness seems likely.
A weak euro is good news for exporters operating in the core of Europe. It makes them more competitive on the world stage and increases the value of their overseas earnings. We have already seen the UK benefit from this theme. Sterling was weak on the foreign exchange markets last year and recent data on exports, as well as quarterly results from firms with global operations, have shown the positive impact a weak currencycan have.
The tailwind provided by a weak currency, together with recovering growth in core Europe and the operational gearing benefits of cost-cutting undertaken during the downturn, give us confidence in the outlook for European corporate profits.
We foresee aggregate earnings’ growth of around 25 per cent in 2010. Much of the recent volatility in world markets has been a result of investors questioning earnings momentum into 2011. We expect a modest slowdown compared with this year but earnings are still expected to grow by a further 15 per cent next year.
The forecasts outlined above should see aggregate earnings in 2011 return to 2007’s levels. Meanwhile, the market is now 40 per cent lower than at the earnings’ peak. As a result, valuations look attractive.
Our predictions place the European equity market on a price/earnings multiple of 10.7 times 2011 earnings – well below the 10-year average of 18.8 times.
The market is similarly attractive relative to history on other measures, such as price to book (1.6 times versus a 10-year average of 2.6 times) and price to cashflow (8.7 times versus 10.2 times). European equities also offer the most attractive yields on the global stage, with a 2010 prospective dividend yield of 3.5 per cent, rising to 3.8 per cent in 2011. With 10-year Government bond yields at 2.6 per cent, equities are great value relative to bonds.
Companies themselves are seeing the value in markets, as illustrated by an upturn in corporate activity. We expect this to remain a feature in the medium term.
We continue to underweight peripheral Europe and companies that sell into those economies. However, we believe it is unwise to eschew these markets altogether as they feature a number of oversold companies with exposure to faster-growing overseas economies.
For example, we are invested in some Spanish companies that are generating strong profits from their Latin American operations. In terms of sectors, we are running a balanced strategy between defensive, secular growth companies and more cyclical businesses, whose earnings are geared into improving global growth, and especially strong emerging market demand.
On the defensive side, we favour consumer staples and healthcare over telecoms and utilities. Given the regulatory and competitive pressures facing the latter sectors, we see them as value traps. Our more cyclical exposure is coming primarily via mining and industrial companies. We remain cautious on financials.
Although some European economies face major headwinds to growth in the coming quarters, the global economy continues to recover and, meanwhile, the weak euro and cost-cutting undertaken during the recession are boosting earnings’ growth potential.
Based on our forecasts, European equities are trading well below their historical averages on a number of valuation measures and are also looking very cheap relative to bonds.
William Davies is head of European equities at Threadneedle