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European Large Caps

Cheaper for a reason?

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Editorial

European Large Caps

Similarities and differences

An expensive safer haven or a cheaper, but more risky option? This is how you could summarize, in one sentence, the alternatives faced by investors who have to choose between U.S. and European equities. The current third-quarter reporting season will again offer reason enough to compare the pros and cons of both regions from an investor’s standpoint. Although the topic of this report is European blue chips, we would like to spend a moment and consider them in contrast to their U.S. peers. Surely there is a wealth of similarities between them, such as a dependency on central banks, historically low economic growth and looming political risks. More interesting, however, are their differences and particularly the reasons for the better performance of U.S. stock markets since the financial crisis – a development we would like to take a closer look at in this report.

The economic and political environment

The European economy held up relatively well, even in the face of risks that dominated the summer such as Brexit, the Italian banking sector, Spain’s (non-)government crisis, and the now common topics of migration and the divergence in the Eurozone. Whereas the Brexit vote had little effect on Continental Europe’s economic indicators, several of the indicators in the United Kingdom (UK) initially tumbled before making a relatively quick recovery. Still, we expect Brexit’s impact to be profoundly negative in the coming year and foresee gross-domestic-product (GDP) growth of just 0.8 % in the UK and 1.2 % in the Eurozone. The cause for the subdued forecast is not only Brexit but also diminishing support from the oil price and the decline in the euro. We expect 1.5% growth in the Eurozone for the current year. The results of the recent purchasing manager’s survey support this slightly positive outlook: in the Eurozone the index increased to 53.7% in October after registering 52.6% in September with sentiment improving in both the industrial and services sectors1.

In the political arena, the positive and negative news is staying more or less in balance. The Brexit process is gathering some momentum and, based on the rhetoric of the British Government, seems no longer avoidable. Whether Prime Minister Theresa May stays with her decision (a “hard” Brexit, if that is the only way for Great Britain to regain control of its borders) remains to be seen. Especially when businesses’ and consumer skepticism about the outcome of such an approach is on the rise (partly due to the weak British pound). Recent events surrounding the European-Canadian CETA trade deal could be cause for both hope and fear in Britain. The fact that the Belgian province of Wallonia has been able to temporarily block an agreement, shows the British how difficult and drawn-out the negotiations could turn out to be on Great Britain’s future relationship with the European Union (EU). At the same time, they could also see it as a confirmation that, at a minimum, it will be quicker to make international agreements outside the EU.

On the topic of central banks, we do not expect any significant change in the easy, pro-equity-market monetary policy from the European Central Bank (ECB) in the next twelve months.

Equities

Why does Europe trail the U.S.?

From a local-currency perspective, there are only two parameters driving indices – increasing earnings per share and higher valuations through rising price-to-earnings ratios (P/E ratios). The following chart shows how U.S. earnings have shot ahead of Europe’s since 2009.

Record gap between U.S. and European earnings (MSCI Europe Index vs. MSCI United States Index)

Record gap between U.S. and European earnings

Source: Thomson Reuters Datastream, MSCI, IBES; ; as of 9/30/16

The next chart shows earnings momentum as the key driver of U.S. equity outperformance and not a significant divergence in the development of P/E ratios.

Earnings and prices of European equities equally weak compared to U.S. peers (MSCI Europe Index vs. MSCI United States Index)

Earnings and prices of European equities equally weak compared to U.S. peers

Source: Thomson Reuters Datastream, MSCI, IBES; as of: 9/30/16

The story is a little different when viewing companies’ share prices relative to their book values. Since 2006, European valuation multiples have dropped significantly in comparison to those in the United States. In terms of book value, European equities today are valued at just 60% of those in the United States. The obvious reason for this is the lower returns on equity generated by European companies versus their U.S. counterparts.

European vs. U.S. returns on equity and book values near record low (MSCI Europe Index vs. MSCI United States Index)

European vs. U.S. returns on equity and book values near record low

Source: Thomson Reuters Datastream, MSCI, IBES; as of: 9/30/16

Why do U.S. equities have higher earnings momentum? We’ve taken a look at several factors, some of which offer a better and others poorer explanation.

What turned out to have little bearing on momentum was the composition of the index. Although it’s true that the MSCI United States Index profited from a lower share of financial and commodity companies and higher share of technology companies versus the MSCI Europe Index, a sector comparison shows that almost all of the U.S. sectors had stronger earnings momentum than those in Europe. Research by Morgan Stanley2 found that over the past five years the composition of the indices could not account for even a tenth of the difference in the return on equity for the two regions’ markets as a whole.

Lower revenue growth for European equities also could not be used to explain the difference in returns because the development in Europe has run almost parallel to that of the United States since the financial crisis.

So, the difference must lie in profitability. If you work your way down the profit-and-loss statements, two key drivers stand out: American companies have higher operating margins, and they buy back a higher volume of shares.

To what extent can the past explain the future?

In our opinion, these last two factors should turn out to have a less impact or possibly even the opposite effect going forward. For one, we believe that the profit margins of U.S. companies hovering at record levels could come under pressure. A key argument for this is the fact that labor costs are outpacing producer prices. We also see a slowdown in share-buyback momentum and believe three factors are mainly responsible: the strong increase in net debt at U.S. companies, the anticipation of rising interest rates and the waning enthusiasm of shareholders to allocate funds for this purpose. U.S. companies have been by far the largest buyers of U.S. shares in recent years via share buybacks and acquisitions.

Current outlook

We do not expect U.S. or European indices to appreciate much in the next twelve months. Our outlook for the end of September 2017 is 2,190 points for the S&P 500 Index, 340 points for the Stoxx 600 and 3,050 points for the EuroStoxx 50 Index. We expect volatile, sideways-moving markets that could see exaggerated moves to both the upside and downside, which should be used tactically. Real momentum is likely to be found outside the indices in both sectors and individual stocks with investors continuing to favor reliable dividend payers.

Until the end of the year, we expect Europe’s stock markets to be caught up in an array of positive and negative factors. An absence of larger shocks (the Brexit process, China’s slowdown and Italy’s banking sector) has already fueled the markets in the summer as has better macroeconomic data (purchasing managers index, consumer sentiment, loan supply). Should the positive data continue, which appears likely, it could propel markets higher. Sustained positive news out of China and other emerging countries could also create momentum because European exporters would stand to benefit more from this than U.S. exporters. Conversely, a continued stabilization in the oil price could have a stronger positive effect on U.S. stock markets than on those in Europe. Still, European equities are profiting this year from trailing other markets and appearing inexpensive. That said, the referendum in Italy and the Brexit negotiations are two looming political risk factors with still no sign of a consensus of opinion among the UK and the rest of the EU. Migration, the rise of populist parties and the stability of the European banking sector are also topics that could continue to produce negative surprises. Indices in Europe are heavily weighted in banks, which means achieving a noticeable pick-up in earnings momentum next year will strongly depend on the financial sector. Investors also should not underestimate the risk of weaker data out of China, which is being largely propped up by political stimuli.

Reporting season and earnings expectations

This year, as almost every year, analysts have been forced to lower their earnings estimates. Consensus estimates, however, have stabilized since the summer and based on the first reports of the current reporting season it appears this trend has managed to continue. In the United States, the companies in the S&P 500 Index that have reported up until October 27 (representing a little more than half of the index), delivered only minor positive surprises overall, recording a year-on-year rise in earnings per share of 3.4% and 2.7% higher sales. Earnings per share of the Stoxx 600 companies increased 12.9% on higher sales of 4.1%. Although these figures reflect only 39% of the index (based on market capitalization), earnings growth is substantially higher than the expectations of a decline of 3%. Financials have been one of the sectors that have been delivering most of the positive surprises. Still, we believe the 13.5% earnings growth expected by the market for 2017 is pretty ambitious3.

Earnings revisions in Europe have stabilized since the summer (MSCI Euro Index – Trend in earnings-per-share expectations (year-on-year growth) for the current year

Earnings revisions in Europe have stabilized since the summer

Source: Thomson Reuters Datastream, MSCI, IBES; as of: 9/30/16

European sector outlook

We continue to generally favor individual structural-growth stocks, such as those in the IT sector. We also prefer defensive industrial stocks and are becoming more positive on the energy and commodity sectors. We are still cautious with respect to financial stocks, even though there are some solid companies at the individual stock level.

Overweight:

  • Energy: Significantly better cost structures after restructuring and a declining risk of dividend cuts place the sector in a better light. In addition, the tone of the OPEC is now more constructive. The likely bottom in investment spending is a plus for top oil-service providers.

  • Healthcare Services: Our focus in this sector is also on quality in the form of companies with a strong growth outlook.

  • IT: Despite worries of shrinking budgets, we see some interesting sub segments such as data centers as well as cloud and data analysis.

Underweight:

  • Financials/Banks: The environment is still plagued by an increase in costly regulatory requirements as well as margin pressure from the low-interest-rate environment.

  • Consumer Staples: The high valuations are vulnerable given the low food-price inflation.

1 Source: Bloomberg Finance L.P., as of 10/2016

2As of 09/2016

3Source: Bloomberg Finance L.P., Deutsche Bank Research, Deutsche Asset Management Investment GmbH, as of: 10/28/16

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