Are investors ignoring the outlook for earnings in Europe?
Although stimulus measures will help the economic recovery, equity markets seem to be ignoring the full impact of the pandemic on companies’ balance sheets.
European equities posted solid gains in April, while oil prices continued to remain subdued as growth concerns weigh on demand. Meanwhile, private business surveys hit record lows as they started to report the damage done by the Covid-19 crisis.
The eurozone economy is likely to register the largest contraction in the first half of the year since the great depression in the 1930s. However, European equities (MSCI Europe ex UK) are up 20% from the mid-March lows (as of 6 May), supported by a stabilisation in the number of Covid-19 infections and the extraordinary fiscal and monetary policy measures provided by European authorities.
Markets are focusing on the prospect of a return to normal once the lockdown measures are lifted and are not paying attention to a key driver of equity returns: earnings. Equity investors are indeed shrugging off the recent bad earnings, with the recent rebound in stock markets being driven by significant re-rating.
Chart 1 shows a substantial pick-up in in multiple valuations that also hints at a speedy V-shaped recovery. Price-to-earnings (P/E) multiples are now well above their long-term average, with the MSCI Europe ex. UK index currently trading on 16.2x forward P/E, which is just above its pre-Covid-19 crisis level.
To us, that suggests that much of the expected positive news is now already priced in. What we do not think has been priced in, however, is the risk that an easing of lockdown measures could lead to a second wave of Covid-19 outbreaks, forcing governments to impose renewed restrictions.
Navigating the current market environment is challenging as we believe that a severe deterioration in earnings is likely. The magnitude of the economic loss from the lockdown measures is going to be severe, and so will be the hit to companies’ earnings. We therefore believe a cautious approach to equities is appropriate.
Earnings: what we expect
As shown in Chart 2, in our analysis we find a strong correlation between European and US earnings. This should not come as a surprise, given the strong economic link between the two economies, with the US representing 14% of extra-eurozone exports, more than the UK (12.7%) and China (7.2%).
It is also worth noting the substantial role of overseas subsidiaries and that therefore revenues also depend on economic growth outside Europe. We also find that the differential real GDP growth between the two economies is a key driver of European earnings per share (EPS) growth, as it helps explain some of the variability in European earnings.
Our forecasting model for European EPS builds on these two key variables to find that European EPS are likely to shrink 43% year-on-year in 2020, before rebounding 45% year-on-year in 2021. Meanwhile, in the scenario where the coronavirus lingers, in which we expect a jump in secondary infections and renewed lockdowns, EPS growth is expected to decline by more than 50% this year.
Risks around the forecast
It is worth highlighting that there are several risks around our forecasts, as it is difficult to predict how the pandemic will develop and lockdown exit strategies are still uncertain for many countries. What we think is likely to happen is that the consumer will be more cautious.
Amid the dramatic drop in employment levels and uncertainty around how the pandemic will evolve, households will be reluctant to spend in order to create a savings buffer. Businesses could behave in the same way and cut their capital expenditure spending. Lower consumer spending and investment are likely to weigh on the recovery, and this could mean weaker growth and a slower recovery for earnings.
Although a slower rate of Covid-19 infections is positive for investors and stimulus measures will help the economic recovery, we believe that equity investors have become too optimistic too quickly. It is important to note that cyclicals, which are sensitive to the economy, are reacting to the deterioration in economic data, with their P/E ratios declining to their historical average.
Overall, we think equity markets seem to be ignoring the full impact of the pandemic on companies’ balance sheets. Moreover, the Covid-19 outbreak is likely to have a material damage on a company’s earnings, especially for companies in the airlines and auto industry and in the tourism sector.
The views and opinions contained herein are those of Irene Lauro, Economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.