With the French Presidential election
out of the way and European economic data still positive, you would think that a lot of investor cash would now be flowing in the direction of the eurozone.
But while that may be true, the smart money knows economics and politics are not the only factors that have held back returns on eurozone equities in recent years. There is also the failure of economic growth to translate into higher corporate earnings.
Indeed, the eurozone economy has been growing faster than its long-term trend rate of 1.5 per cent since the middle of 2013 but this has not delivered outsized returns for investors, in large part because it has not translated into higher corporate profits.
This year is supposed to be different. The consensus forecast for 2017 is for 14 per cent growth in company earnings year on year for those in the main Stoxx 600 index. That said, the past five years have seen a roughly 11 percentage points gap between the forecast at the start of the year and the end result. What is to stop 2017 being the year of the downgrade once again?
Struggling sectors are bouncing back
One answer to that question is “reality”. Four months into 2017, that 14 per cent earnings forecast had yet to come down at all. If anything, companies are talking up their prospects to analysts, not massaging them down. In each of the past five years, the headline forecast had already come down by four to five percentage points by early spring.
The second reason for cautious optimism is that the sectors most responsible for pulling down European corporate earnings in the past have much less chance of doing so this year.
Around one-quarter of the gap between expected and actual corporate earnings since 2012 has been due to disappointing earnings from oil and gas and basic resources companies. Prospects for these sectors look better this year. Even if we do see another shock, the much lower weight of these two sectors in the main European index puts them in a much weaker position to cause trouble.
In 2012, basic resources and oil and gas accounted for nearly 20 per cent of the corporation earnings in the Stoxx 600. Today that number has fallen to 9 per cent. From here they could suffer the worst downgrade in earnings expectations experienced between 2012 and 2016 and it would only take two to three points off that 14 per cent forecast for corporate earnings growth.
Financials have been the other sector repeatedly taking a bite out of the European earnings numbers, as banks faced successive hits to their profitability due to extremely loose monetary policy and European regulators’ efforts to clean up bank balance sheets. Bank earnings forecasts in 2012 turned out to be 35 percentage points worse than initially hoped, with 2013 and 2014 not a lot better.
There is no getting around it: financials are every bit as important to European earnings today as they were in 2012. Another 35 per cent earnings disappointment from the banks would take that 14 per cent forecast down to 6 to 7 per cent.
Is that likely to happen? Never say never when it comes to Europe. There is still a big political question mark on the horizon in the form of the Italian election, which must be held by May 2018. Longer term, we do not know whether the new French President really will carve a fresh relationship with Germany or push through pro-growth reforms.
However, it is difficult to see how the financial sector could face another big reversal in 2017. Lending to companies continues to rise, bank balance sheets are stronger and earnings forecasts since January have actually been revised up.
There is still a big political question mark on the horizon in the form of the Italian election.
It is true the European Central Bank is unlikely to help Europe’s banks by removing its negative interest rate policy this year. But banks do not need to have a banner year for the market as a whole to do well. All that is required is for them not to hit another major roadblock.
After years of disappointment, investors are right not to take today’s upbeat forecasts for European corporate earnings at face value. They have been burned many times before by rosy predictions that do not come true.
But 2017 is already different and there are good reasons to believe it will remain so.
Stephanie Flanders is chief market strategist for Europe at J.P. Morgan Asset Management