The writer is head of European equity strategy at UBS
The European third-quarter reporting season is upon us, providing insights to the broader state of the economy and corporate health in the wake of the Covid-19 pandemic.
It seems likely that the results will show second-quarter earnings marked a low, in terms of both corporate profits and economic activity. European profits were down about 60 per cent year-on-year in that period.
For the third-quarter, the consensus of forecasts is for a fall of roughly 40 per cent year-on-year. That is clearly still a weak performance, but is an improvement nevertheless.
How much visibility do corporates have on the economic outlook? Most attention is focused on the published macroeconomic lead indicators, but feedback from individual corporates can add important colour to our picture of the shape of the economic recovery.
And while the reporting season may be backward-looking, there are ways that companies can signal the path of the recovery, such as the forward guidance in results.
By the end of the second-quarter results season, half of European companies had either cut or fully withdrawn guidance on their outlook given uncertainties over the impact of the pandemic. Perhaps more surprisingly, 40 per cent of companies had held their guidance, and 10 per cent had actually raised their expectations.
The sectors where companies held or raised guidance tended to be more defensive and less exposed to the economy, such as pharmaceuticals and telecoms. But there were also some more cyclical parts of the market — such as banks and diversified financials — where, on a net basis, more companies held or upgraded than cut their guidance.
Companies also signal how confident they are about the future through the amount of cash they return to investors, and over what time frame. This is perhaps an even more important indicator of how companies view the outlook, as it relates to hard cash and affects the balance sheet, rather than being simply a statement in a results presentation.
Corporate Europe paid out close to €350bn of dividends in 2019, and had grown or maintained the level of dividends for a decade previous to that. Consensus expectations are for dividends to fall roughly 20 per cent this year, but estimates have been steady for three months in a row. Two-thirds of sectors have seen recent upgrades to dividend forecasts — suggesting dividends are bottoming out.
Looking beyond the current reporting season and into 2021, we suspect that consensus forecasts for earnings growth are too optimistic. The consensus is assuming about a 40 per cent bounceback in earnings for next year, but we see risks to those expectations.
The return of mobility restrictions across Europe will act as a drag on the pace of economic recovery from 2020 into 2021. The macroeconomic indicators were already showing signs of plateauing in Europe ahead of the new restrictions. The most recent eurozone composite purchasing managers’ index was close to the break-even level of 50.
And the strength of the euro is likely to be a headwind to corporate earnings, particularly for export-focused companies. We estimate that each 10 per cent appreciation of the trade-weighted euro leads to about a 6 per cent cut in earnings for the overall index.
So where is the upside potential for European equities? We suspect it lies not so much on the earnings side, but rather in the multiple applied to those earnings. European equities are one of the very few global assets that offer a yield — in terms of dividends — in line with its 30-year average.
In a world starved of yield, this could allow for a further re-rating of equities and an expansion of valuation multiples. European equities trade on a multiple of their expected earnings over the next 12 months of 17 times, a slight premium to the long run average of 15 times.
Other potential gains could come from some form of effective vaccine for Covid-19. The equity market has been reacting sharply to any positive newsflow on progress around vaccines.
Other potential positives include a further large fiscal stimulus from the US, the planned EU economic recovery fund and the possibility of US investors returning to European equities.
In the near term, there might be a modest fading in the European market into the year end given the economic uncertainties and Covid restrictions. Over the longer term as dividend payouts recover in a world of low fixed-income yields, we suspect that European equities will be an attractive asset class.
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