Equities: Company earnings are improving… at last!

Stock markets reacted very positively to the results of round one of the French presidential election. European indices rebounded by 2-4% on Monday 24 April. The hope of softer political risks in Europe will allow investors to focus on economic fundamentals. But are they really that good?

In addition to economic data, another way of assessing the health of the eurozone is to follow the EPS (earnings per share) outlook. Over the past few quarters, the trend has been quite encouraging.  Companies have seen their earnings surprise to the upside and even resume the growth track.  

Positive earnings growth

For several years, European companies have been stuck in a complicated environment (sovereign debt crisis, low domestic demand, fears of secular stagnation, etc.). Against this backdrop, EPS growth has remained anaemic, and trends have been clearly less favourable than in the US, which has benefited from a perkier economic climate (see graph below).  However, the outlook seems to be improving in Europe.

Several factors herald a rebound in earnings:

1) Favourable macro-economic effects:
 

• Growing demand: Macro-economic indices are improving, reflecting a better economic climate. Companies have fuller order books and can now see a brighter future. Consequently, demand and revenues are set to increase.
• Profit margins should improve: Firstly, the upbeat economic climate will give companies more pricing power (the capacity to raise selling prices). Indeed, the deflationary risk has faded in recent quarters. Secondly, with the expected growth in revenues, companies will enjoy higher operational leverage which will automatically expand margins. Companies with high fixed costs will be the first to reap the benefits;
• The weak euro is finally an advantage for exporting companies.

2) Technical effects:
 

• Very favourable base effects. The start of 2016 was marked by very low profitability in certain sectors. For example, the sharp fall in oil prices at the end of 2015 severely penalised oil groups. Since this date, the rebound in the barrel price has pointed to a strong recovery in earnings growth in 2017.   The markets expect a 40% rise in earnings in the energy sector. Likewise, the banking sector is benefiting from this growth thanks to very positive base effects (2016 was a challenging year for banks).

Encouraging first quarter 2017 results

The reporting season for the first quarter of 2017 is underway. Indeed, it is a very busy time at the moment with respectively 41% and 33% of the results scheduled for release during the week of 24 April in the US and Europe¹. At this stage, there have been more releases in the US than in Europe. So, we can already draw some conclusions about the US results.

Overall, the figures are pretty reassuring:
 

• Earnings per share (EPS) growth in 1H17 was 12% y/y;
• US banks continued to consolidate the improvement in profitability thanks to the effects of the reflation trade (Fed rate hikes, increase in loan applications);
• Despite a firmer dollar, global cyclical stocks (particularly technology and materials) benefited from a more favourable world economic environment;
• The only fly in the ointment is the transport sector (airline companies) which was stung by higher oil prices; so far, the EPS published of US companies have come in above expectations (5% above consensus). Consequently, analysts are revising up their forecasts, particularly for very cyclical sectors. Companies share this optimism and, in turn, are revising up their guidance.

Although it is too early to draw conclusions, this trend augurs well for good results in Europe. For the second consecutive quarter, and after a long recession, European companies’ should finally grow their revenues, thanks to the healthier economic climate. EPS figures are also expected to the upside year-on-year (+7%), driven by energy (+40%). However, utilities are likely to continue to suffer from their dismal profitability (-44%).  

The game is not yet over, and stock markets may still react unexpectedly. However, if political risks diminish, investors might turn their attention to the quality of European company earnings. In particular they should analyse the evolution of profit margins and the capacity of companies to capture the expected uplift in revenues thanks to better economic conditions. In Europe, cyclical and bank stocks appear to be in the best position to do this.