Download European Equity THE EUROPEAN EARNINGS

PRICE
POINT
April 2017
Timely intelligence and
analysis for our clients.
European Equity
THE EUROPEAN EARNINGS SEASON
CONFIRMS CORPORATE RESILIENCE
KEY POINTS
Dean Tenerelli
Portfolio Manager,
Europe Equity Strategy
 The recent earnings season, now drawing to a conclusion, confirms an optimistic
outlook for European earnings growth. In recent weeks there has been a modest
upward pressure on estimates for European earnings growth this year, with
consensus expectations now standing at around 14% in 2017.
 The resilience in market earnings forecasts is in sharp contrast to the pattern seen in
recent years. In each of the past five years (2012–2016) consensus estimates have
declined materially in the first quarter. In each case, estimates continued to be
reduced through the rest of the year.
 There has been a dramatic rotation in the European market in the last 12 months or
so, presenting investors with a range of new opportunities but also potential risks.
We continue to deploy capital in better-quality companies in areas of the market
where our valuation signal suggests an attractive risk/reward trade-off.
 If earnings growth is realized this year and beyond, then this should give investors
greater confidence about the valuation opportunity that exists in European equities.
The recent earnings season, now drawing to a conclusion, confirms an optimistic
1
outlook for European earnings growth. Analysis highlights that earnings in the most
recent quarter grew by 10%, with more companies surprising positively than
negatively.
There was a good breadth to this performance, with earnings in all but one European
market sectors advancing (10 of 11, with energy the exception). Although investors
appear to be more focused on the potential for further earnings growth in the U.S., the
advance in that market was a lesser 5%. Furthermore, in recent weeks there has been
a modest upward pressure on estimates for European earnings growth this year,
2
with consensus expectations now standing at around 14% in 2017. In comparison,
expectations in the U.S. have slipped from the start of the year, with a lower rate of
growth now expected than in Europe.
1
Source: J.P. Morgan, as of March 2017.
Source: FactSet, as of March 2017.
2
Figure 1: European earnings estimates in 2017—A sharp contrast to recent years
EPS Estimates Through Time, Percent, Year-on-Year
20%
2012
2013
2014
2015
2016
2017
2018
15%
10%
5%
0%
-5%
-10%
2012
2013
2014
2015
2016
2017
Sources: Morgan Stanley and FactSet, as of February 2017. Past performance is not a reliable indicator of future performance.
The resilience in market earnings forecasts is in sharp contrast to the pattern we have seen in recent years.
Figure 1 demonstrates how consensus estimates have declined materially in the first quarter for each of the last
five years (2012–2016) with growth estimates reduced by an average of four percentage points in the first quarter
in that period. In each case, estimates continued to be reduced throughout the rest of the year, and the overall
path of earnings was disappointing over a sustained period. Figure 2 confirms that as a result, earnings in Europe
are still materially below the level achieved 10 years ago, whereas there has been a sharp recovery in
the U.S.
Figure 2: European earnings still have some way to go
Local, December 2006 + 100
Earnings Per Share Relative to History
140
130
120
110
100
90
80
70
60
50
40
2007
MSCI Europe
S&P 500
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
Sources: MSCI and FactSet, as of February 2017. Past performance is not a reliable indicator of future performance.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data
contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products.
This report is not approved, reviewed, or produced by MSCI.
This erosion was caused by a number of factors, to varying degrees. A very sluggish domestic economy—more
than expected—has been a consistent drag. Slower-than-expected growth in emerging markets and, to a lesser
extent, the U.S. has been a constraint in recent years. The collapse in commodity prices in 2014–2015
PRICE PO INT
2
2
2
dramatically undermined the results of most components in the energy and materials sectors. A consistent
headwind has also been the structural downward shift in the earnings of the financials sector, due to the
challenges of greater regulation, disruptions to business models, and very low interest rates.
My style of investment is more focused on identifying longer-term fundamental strengths of businesses, rather
than short-term earnings momentum. However, I also look for a pattern of predictability in performance, which is a
natural by-product of a good-quality company. In addition, as I seek to ensure that the portfolio is appropriately
balanced, I look for it to perform in a range of market conditions. The current environment continues to be one
marked by hopes of “reflation” and better global growth, as reflected in valuations of some cyclical areas of the
market. So I have been reassured by the overall operational performance of the companies in the portfolio. In
aggregate, the reported results of my holdings were close to expectations, and there has been a modest upward
movement in earnings estimates for the current year.
Uncertainties remain about the path of the economic cycle and, in some of those cyclical parts of the market, what
could prove to be optimistic medium-term scenarios, in my view, are being discounted. But the economic
fundamentals do appear to be improving in Europe, as evidenced by hard data and surveys such as purchasing
managers’ index (PMI) readings.
HOW ARE WE PLAYING THIS BACKDROP?
There has been a dramatic rotation in the European market in the last 12 months or so, presenting investors with
a range of new opportunities but also potential risks. We continue to deploy capital in better-quality companies in
areas of the market where our valuation signal suggests an attractive risk/reward trade-off. At the margin we are
finding more of these opportunities in more defensive areas, such as in telecoms and regulated utilities. This is
being balanced by our increased exposure to financials—specifically, well-managed franchises in consolidating
markets—which we expect to benefit from changes in expectations about inflation, interest rates, and growth.
Figure 3: European valuations remain low versus history and other developed markets
Cyclically Adjusted Real Price-to-Earnings (P/E) Ratio
50
Europe (Avg = 19.5)
USA (Avg = 23.9)
Japan (Avg = 43.4)
P/E Ratio
40
30
20
10
0
1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
Sources: MSCI and FactSet, as of February 2017. Past performance is not a reliable indicator of future performance.
PRICE PO INT
3
3
3
Figure 4: European valuations based on next 12 months expected earnings
Price-to-Earnings (P/E) Ratio (Next 13 Months)
30
Europe (Avg = 13.7)
USA (Avg = 15.5)
25
P/E Ratio
20
15
10
5
0
1996
1999
2002
2005
2008
2011
2014
2017
Sources: MSCI and FactSet, as of February 2017. Past performance is not a reliable indicator of future performance.
If earnings growth is realized this year and beyond, then this should give investors greater confidence about the
valuation opportunity that exists in European equities. Figure 3 shows that on a “normalized,” cyclically adjusted
basis (using the average of the last 10 years of earnings), the European market is still on a relatively low rate
versus its own history, and also versus other developed markets. Using expectations for the next 12 months, as
depicted in Figure 4, the European market may be trading at a slight premium to its longer-term average. But
further positive earnings momentum should help to bridge the gap, and provide support.
PRICE PO INT
4
4
4
Important Information
This material, including any statements, information, data and content contained within it and any materials, information, images, links,
graphics or recording provided in conjunction with this material are being furnished by T. Rowe Price for general informational purposes only.
The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries
the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction. Under no circumstances
should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price. The material does not constitute a
distribution, an offer, an invitation, recommendation or solicitation to sell or buy any securities in any jurisdiction. The material has not been
reviewed by any regulatory authority in any jurisdiction. The material does not constitute advice of any nature and prospective investors are
recommended to seek independent legal, financial and tax advice before making any investment decision. Past performance is not a reliable
indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less
than the amount invested.
The views contained herein are as of April 2017 and may have changed since that time.
Australia—Issued in Australia by T. Rowe Price International Ltd (ABN 84 104 852 191), Level 50, Governor Phillip Tower, 1 Farrer Place,
Suite 50B, Sydney, NSW 2000, Australia. T. Rowe Price International Ltd is exempt from the requirement to hold an Australian financial
services licence in respect of the financial services it provides in Australia. T. Rowe Price International Ltd is authorised and regulated by the
UK Financial Conduct Authority under UK laws, which differ from Australian laws. For Wholesale Clients only.
Canada—Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only
available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation
agreements with affiliates to provide investment management services.
DIFC—Issued in the Dubai International Financial Centre by T. Rowe Price International Ltd. This material is communicated on behalf of
T. Rowe Price International Ltd by its representative office which is regulated by the Dubai Financial Services Authority. For Professional
Clients only.
EEA—Issued in the European Economic Area by T. Rowe Price International Ltd, 60 Queen Victoria Street, London EC4N 4TZ which is
authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.
Hong Kong—Issued in Hong Kong by T. Rowe Price Hong Kong Limited, 21/F, Jardine House, 1 Connaught Place, Central, Hong Kong.
T. Rowe Price Hong Kong Limited is licensed and regulated by the Securities & Futures Commission. For Professional Investors only.
Singapore—Issued in Singapore by T. Rowe Price Singapore Private Ltd., No. 501 Orchard Rd, #10-02 Wheelock Place, Singapore 238880.
T. Rowe Price Singapore Private Ltd. is licensed and regulated by the Monetary Authority of Singapore. For Institutional and Accredited
Investors only.
Switzerland—Issued in Switzerland by T. Rowe Price (Switzerland) GmbH ("TRPSWISS"), Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland.
For Qualified Investors only.
USA (public)—Issued in the USA by T. Rowe Price Associates, Inc., and by T. Rowe Price Investment Services, Inc., 100 East Pratt Street,
Baltimore, MD, 21202.
T. ROWE PRICE, INVEST WITH CONFIDENCE and the Bighorn Sheep design are, collectively and/or apart, trademarks or registered
trademarks of T. Rowe Price Group, Inc. in the United States, European Union, and other countries. This material is intended for use only in
select countries.
2017 03-1 317 81
4/17