The robust pace of earnings growth points to favourable long-term prospects for the eurozone. But strong global demand has led to unexpected supply chain problems for smaller industrials.
The turbulence caused by the American subprime mortgage market and the significant widening of credit spreads has buffeted European equity markets over recent weeks. However, although markets could well see further volatility over the coming weeks, the longer-term prospects remain favourable.
One reason we are maintaining a positive stance is the healthy pace of corporate earnings growth. The second quarter reporting season was generally well received by investors, despite more upsets than in previous quarters. With hindsight, this was not too surprising given that analysts’ expectations for second-quarter earnings were high. What was surprising, however, was that some of the earnings disappointments were in the industrials sector, as this area is a beneficiary of the strong global economic climate.
The problems were not attributable to weaker sales growth but to companies struggling to contain their input costs or manage their pace of expansion. And while admittedly some companies have found it harder to sustain their sales momentum in America, the impact has been mitigated by strong sales growth in Asia, Europe and the Middle East, where demand remains strong. Overall, we forecast European earnings growth of 8.0% for 2007, followed by an easing to 6.0% in 2008.
Such has been the strength of global demand for industrial products that some European manufacturers have had difficulty in securing adequate supplies of components. Consequently, some of the recent earnings disappointments have been among small and medium-sized industrials that lack the market strength to compete with the demands and the financial muscle of larger operators for the materials they need.
Moreover, some company management teams have not been sufficiently experienced to manage the rise in demand for their products. It is more important to have confidence in the company’s management and its ability to operate successfully in the supply chain. Many companies are increasing their capital expenditure and it is imperative to look carefully at the major beneficiaries of this spending.
It is crucial to be invested in well-managed companies operating from a position of strength in terms of their relationships with their customers and suppliers. The latter relationship is particularly important given the upward pressures on many input costs and the emergence of bottlenecks in the supply of components.
Corporate pricing power based on a strong market position is key in the present environment. The most attractive areas are those that are still at the beginning of their growth phases, such as power generation and oil services. The latter companies are well placed to expand their sales and earnings as the pace of oil exploration continues to grow. Overall, it is best to favour industrial companies that can retain their pricing power and avoid those where it is only transitory.
At country level, German stocks were hit particularly hard by the recent market turbulence as concerns over a possible credit crunch caused higher beta markets to fall.
From an economic standpoint, the outlook for European equity markets continues to be positive. Economic growth within the eurozone is now better balanced, and while Spain and Ireland are seeing slower activity because of weaker property markets, growth in the core economies has improved.
We are forecasting GDP growth of 2.75% for the eurozone in 2007, followed by a modest slowing to 2.5% in 2008. This compares with growth of just 1.5% in 2005.
Against the brighter growth outlook and the risk of increased inflationary pressures, the European Central Bank (ECB) is likely to remain in tightening mode. However, there are signs that political pressure could increase, especially if the euro strengthens further against the dollar in the faceof any marked weakening of the American economy.
While robust earnings growth should help to underpin European equities, markets will find it difficult to make sustained progress while the present uncertainties persist. In the short term, investors will continue to focus their attention on America, where the problems in the housing market could significantly dampen retail spending (American consumers account for 20% of global consumption).
Additionally, the widening of credit spreads is likely to have implications for the strength of corporate activity, which has been a key factor fuelling the rise in equity markets. Although mergers and acquisitions activity is unlikely to evaporate, highly leveraged deals will become less attractive and more difficult to finance. This could prove a positive for well-capitalised European companies, which will see reduced competition from private equity firms for attractive acquisitions.
Finally, at current levels European equities continue to look attractively valued, with markets trading on a prospective price/earnings multiple (P/E) of about 13.3 for 2008. This looks favourable both from a global perspective and by historical comparison. Over the past 10 years the average forward P/E has been about 18.