09 May 2016

Watching European equities can at times feel like watching a play, with figures such as European Central Bank president Mario Draghi and German finance minister Wolfgang Schäuble the leading actors.

But rather than wondering whether we’re seeing a tragedy or a farce unfold, as investors we should remember that it is the real companies – not the theatrical types – that matter.

That is not to say, of course, that we should ignore the macroeconomic picture altogether. BlackRock’s investment barometer for the second quarter acknowledges that we have seen some improvement here, but concerns remain.

After the volatility of the first quarter, we have seen some reassuring indicators: the US Federal Reserve has struck a more dovish tone, which has stabilised the dollar; US industrial data is encouraging; and it seems the Chinese fiscal stimulus is working. In Europe too the economic data is positive, with improving consumption and industrial reports. A good sign is auto demand, which has grown for the past two years, with particular improvement coming from Spain and Italy. This comes against the backdrop of greater support from the European Central Bank via the latest expansion of its quantitative easing programme, especially with loans to corporates, which should boost European economic growth further.

The most prominent macro risk is Brexit but – although the result may be close, especially if turnout is low – we still believe the British public will vote to remain. Nevertheless, we expect volatility in UK and European markets to rise ahead of the referendum.

As mentioned, though, it is corporate health that really matters to us and it is easy to come to a bleak conclusion here. European earnings growth has sadly deteriorated so far this year, with earnings now negative year-on-year. For the MSCI Europe index, the figure sits at -9% due to weakness in the energy and materials sectors and soft capex trends (Source: Barclays, March 2016; BlackRock European Equity Barometer Q2 2016). Looking forward, earnings expectations have dropped from an already depressed level. Consensus forecasts for year-end earnings growth stand at approximately 1.4%, down from 3.2% at the beginning of the year (Source: Barclays, March 2016; BlackRock European Equity Barometer Q2 2016). With the exception of 2009, this is the lowest level in over 25 years.

We are somewhat more constructive, however. First, the drag caused by the energy and materials sectors seems to be easing as companies have adjusted to the overcapacity glut. Second, given significant earnings downgrades, the opportunity for upside surprises appears greater. Third, subdued inflation means that there should be less cost pressure on companies, which helps their profits. We have therefore not changed our forecasts on earnings growth of around 5%-7% for this year.

As investors, we must also consider what we are paying for this earnings growth. European equities have recovered from their lows in the first quarter, so we feel that valuations are no longer particularly cheap on a price-to-earnings basis. We must therefore continue to focus on stock selection, and we are sticking to companies that offer attractive earnings momentum and stock-specific drivers while looking to avoid value traps in highly cyclical businesses without momentum.

So while the combination of a more supportive macroeconomic backdrop and sharply reduced expectations for European earnings offers hope for a positive surprise, we believe that we need to see companies deliver earnings growth to drive meaningful upside for European equities.

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Given significant earnings downgrades, the opportunity for upside surprises appears greater.