What is the outlook for European equities at this stage of the business cycle?

The manufacturing purchasing managers’ index (PMI) surveys are among the most important data points for gauging where we are in the business cycle. The February PMI surveys confirmed that the eurozone economy continues to expand, albeit at a relatively modest rate. The manufacturing PMI survey reached 53.2 for the month, falling back slightly from January’s 54.0 reading. Nonetheless, orders outpaced inventory by a ratio of 1.13, suggesting reasonable support for the next few months. We look closely at new orders as these give a three to six month lead on where the revenue line in the manufacturing sector is heading. After the surge in PMIs witnessed since last summer, we would expect earnings upgrades to start coming through this year. In this regard, the UK appears slightly ahead of continental Europe and is close to shifting from peak cycle into slowdown.

Credit risk is a topic that remains high on the agenda in most markets, given that the global economy is in effect emerging from a credit depression. The credit cycle is driven by two factors: the supply of credit and the demand for credit. Encouragingly, the cost of credit has fallen and we are starting to see rising demand for credit, even in the eurozone periphery, which is an important sign of an improving economy. In addition, we are close to a turning point in the supply of credit in Europe. Banks have been deleveraging for four years but are now nearing the end of that process and in fact are expecting to increase their loan growth in 2014. That is the first real positive sign that we have seen on the credit availability front in several years. What is also notable is that peripheral eurozone economies such as Spain are leading the way.

Credit impulse is turning up across the euro area Source: Schroders, Deutsche Bank, ECB, Eurostat to end Q3 2013. Credit impulse is the rate of change of credit in the economy.

Rising demand for credit from corporates is a sign of increased confidence in the prospects for the economy. What we need for the nascent recovery to become self-sustaining is an increase in capital expenditure. The trend in Europe over the past two decades has been for disinvestment as companies have shifted production to cheaper parts of the world. However, with renewed worries over emerging market economies and the recovery in Europe gaining traction, we think capital expenditure is due to rise in Europe. This should be positive for earnings as corporates seek to invest and expand. A further sign of rising confidence is the pick-up in merger and acquisition activity that we have seen recently, both within Europe and from European companies overseas.

The European earnings cycle has been depressed, mainly due to the austerity measures imposed in most of the region’s major economies. European earnings remain some 30% below their peak. By contrast, US earnings have recovered much more quickly and have already passed their previous peak. This is largely down to the action taken by the US Federal Reserve in implementing policies such as quantitative easing, whereas the European Central Bank (ECB) has not been so generous in its measures to support the economy. The ECB could yet announce further action if inflation remains substantially below target, although we believe that the earnings cycle is set to improve in Europe anyway. There is plenty of earnings potential still to come, particularly in the financials sector.

Banks have been seen as one of the riskier sectors in Europe; however, the risk of a bank default has receded significantly. The European Central Bank is undertaking its Asset Quality Review of the sector this year and we expect most European banks to pass with a clean bill of health. Many banks have already taken measures to prepare for the review although some individual banks may still need to undertake capital increases. Bank equities remain relatively depressed compared to the improvement seen in the credit market so there is scope for them to play catch up.

Bank equities have further to go to catch up with tightening spreads Source: Schroders, DataStream, as at January 2014

Political instability has faded in Western Europe too. The recent change of government in Italy was greeted positively by the market amid hopes that the new prime minister Matteo Renzi will reinvigorate the reform process. Barring any major geopolitical shocks, stock-specific factors look set to be the main drivers of European share prices in the coming months. With the European economy still in its expansion phase, earnings momentum remains the key factor determining share price performance. The full year earnings season has just ended and demonstrated that momentum is still clearly following earnings upgrades. Most recent downgrades have been due to foreign exchange rates and this has resulted in domestically-exposed European stocks outperforming their globally-exposed peers. This trend is likely to continue as long as concerns remain over the outlook for emerging markets. Liquidity flows into Europe at the expense of emerging markets should also provide broader support for European equities.