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The earning curve

In a dramatic turn-round, European equities have seen a rapid rise driven by continuing earnings’ momentum

Alister Hibbert Market View

At the beginning of 2009, the outlook for European equities was bleak. Banks had stopped lending to one another, liquidity was absent from the market and credit had become the scarcest commodity of all.

Investors were exiting equity markets en masse as industrial production all but ceased and companies severely downgraded their earnings’ expectations.

European markets in particular felt the pain as their significant weightings in cyclicals – including financial and industrial firms – caused declines in Europe to be steeper than in many other developed economies.

Almost all indicators were pointing to a dismal future for European equities.

We felt the green shoots of recovery were to be found not among the uniformly negative economic trends but in the very origins of the recession – the pandemic of suspicion in the banks’ balance sheets.

The global response to the downturn was uniformly Keynesian, as central banks slashed interest rates and poured money into the economy to stimulate demand and provide the banks with a much-needed lifeline.

By March, credit had returned to the marketplace. This allowed companies to finance themselves properly but also meant global investment banks were returning to profitability.

“The outlook for European equity markets remains positive against a backdrop of recovering earnings’ momentum, cheap valuations and continued government stimulus tailwinds.”

European equities bottomed out on March 9, as investment banks began to report exponentially better than expected earnings. This, in turn, helped to fundamentally improve banks’ balance sheets and proved the first step on the road to recovery.

European equities have enjoyed a remarkable rebound since March, outperforming their counterparts through- out the developed world.

Between March 9 and September 30, the MSCI Europe rose by 53 per cent in euro terms. Economic conditions have steadily improved as business confidence indicators and industrial production have turned positive.

Perhaps most important, however, is the region’s return to profitability.

There were strong gains in share prices as companies posted surprisingly good second and third-quarter earnings. The aggressive cost-cutting implemented by European firms suggests they may continue to beat expectations as volumes return on the back of stronger demand.

European equity valuation multiples are clearly higher than in March as the market has experienced sharp quarter-on-quarter gains. However, we believe Europe remains a fertile hunting ground for high quality businesses with strong earnings’ growth potential at extremely attractive valuations.

Notably, Europe offers a higher level of emerging market exposure than the US and has a heavier weighting of financials, many of which have low valuations.

The outlook for European equity markets remains positive against a backdrop of recovering earnings’ momentum, cheap valuations and continued government stimulus tailwinds. With many companies taking the opportunity to raise capital via right issues, balance sheets are looking healthy and M&A activity may once again be back on the agenda.

We believe the economic recovery will continue to gain momentum and current consensus earnings’ forecasts may underestimate the potential earnings upside, especially when faced with further aggressive cost- cutting by companies and a recovery in demand.

Looking ahead, we expect market returns to be driven by stock-specific factors, such as earnings’ upgrades and positive company newsflow. In our view, this environment is well suited to our bottom- up fundamental investment approach and our portfolio contains a number of extremely exciting investment ideas with significant potential for upside over coming months.

Alister Hibbert is fund manager of the Black Rock European dynamic fund


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