As 2017 progresses, the macroeconomic backdrop appears to paint a rosy picture for European equities. Yet the gap between European and US corporate earnings stubbornly persists. According to Dylan Ball, Executive Vice President, Templeton Global Equity Group, that situation may be about to change. In fact, he believes that the prospects for rising inflation in the Eurozone could be a catalyst that can close the earnings gap.
After a year in which political surprises dominated the scene around the world, we believe the conditions are finally shaping for a good year for European equities. Recent experience indicates that equity markets generally have problems pricing in political events. However, we believe that policy does not dictate long-term equity market performance, but provides an immediate opportunity to exploit long-term trends.
As value investors, we try to stay focused on a long-term investment horizon and use volatility as
opportunity to research undervalued companies.
Positive macroeconomic environment
The depreciated euro, credit cycle dynamics and the easing of austerity measures across the continent are overall positive factors for European equities. We believe the most important driver for the asset class in 2017 is the prospect of rising inflation, which now looks set to materialise. In our view, inflation should be positive for European earnings.
Inflation has traditionally moved three to four months behind the trend in energy and raw material prices. In September of last year, the price of oil had recovered from historic lows, returning to around 50 US dollars a barrel. The effect of this price increase is now emerging in the inflation data, which lead us to believe that Europe could move from an inflation environment in the order of 1%-2% to one probably around 3 %-4%.
HOW SUSTAINABLE IS THE INFLATION THESIS?
We believe several factors point to a sustained period of higher inflation across Europe. Our base case points to higher oil and commodity prices, as we believe the prices of important commodities showed signs of recovering from troughs in the second or third quarter of 2016. An increase in infrastructure spending in the US and Europe should support the bullish momentum. The trend in oil prices continues to be dictated by supply. We don't have a crystal ball, but our research and calculations indicate that global oil demand could sustain a price above the recent US$55 a barrel.
After all, the demand for oil continues to grow at a rate of 1%-2% annually worldwide. While an increase in the number of oil wells in the United States can go some way to meeting the growth in demand, members of the Organization of the Petroleum Exporting Countries (OPEC) appear willing to limit production in order to push up i
oil prices. Meanwhile, during recent research trips to Europe, we have seen some signs that the stimulus debate is shifting from monetary to fiscal policy.
Some have suggested that if the President of the United States, Donald Trump, were to take the path of fiscal leverage, starting spending and construction, certain European countries, for example Germany, could consider similar measures. Furthermore, if the Trump administration were to insist on the more protectionist programs supported by the newly elected president during his election campaign, these too could have an inflationary effect by translating into an increase in the prices of imports.
Why is this important for European earnings?
A gap stubbornly persists between European and US earnings that has not been closed for many years. European earnings currently remain 60% below some 2008-2009 peaks, while US earnings are 10%
above the levels of eight to nine years ago. Observers blamed this discrepancy for several reasons, including the argument that the type of monetary policy pursued by the European Central Bank cannot function effectively without a fiscal union.
Another hypothesis is the positive impact on earnings of share buybacks in the United States, where the tax regime has traditionally been favorable to such measures. In our view, the key reason why European earnings continue to lag behind US earnings is that profit margins in Europe have not yet achieved the desired recovery. For observers, it might be easy to argue that European labor markets are not as competitive as US ones and cannot respond as nimbly to a decrease in demand. However, we believe that this is not the case; labor costs in Europe have proven to be very competitive, in our view.
Instead, we think the underlying problem is pricing. European companies tend to move according to prices. When inflation falls, European companies tend to cut prices in order to compete with US and Asian ones, while when inflation rises, they tend to increase them. As a result, after European companies react to higher inflation, we would tend to expect the earnings gap to the US to close.
Inflation: Positives for Europe and for value investors
For the past eight to nine years, we have lived in a deflationary environment. As counter-current investors, during this period we were interested in companies that do well in the absence of inflation. Conversely, as inflation moves higher, we believe in a revaluation of industrial, financial and oil & gas stocks in Europe. Looking at the landscape of European equities, it is precisely this appreciation that seems to us to offer an opportunity for long-term returns.
