European profits set for a comeback

Continental stocks have disappointed so far this year. But as Andrew Van Sickle explains, that's all set to change.

"Of all the winning trades predicted for 2016 that have backfired spectacularly, buying European equities tops the list," says Gavin Jackson and Rochelle Toplensky in the Financial Times. European equities, as measured by the pan-European Euro Stoxx 600 index, have fallen by 6% this year. Unlike many indices, it has not recovered the ground lost in January this year during the growth scare. It remains down more than 15% from its 2015 peak, and has also lagged America's S&P 500 since 2011.

So what's gone wrong? A recurring problem, as Switzerland's Finanz und Wirtschaft points out, is constant disappointment on the profit front. The latest season was no exception. Most firms in the index have reported, and so far earnings are down by a fifth year-on-year, with sales falling by 7%.

The current earnings cycle has been the weakest in more than 40 years. After a decent bounce from 2009 to 2011, profits have been declining gently, and are now barely above the 2010 low. The recession induced by the 2011 eurozone crisis was a blow, but the economy has now recovered and moved beyond its pre-crisis size, so you'd think earnings would have too especially given low oil prices, a weak euro boosting exporters, and a supportive central bank trying to encourage investment by keeping interest rates low.

One reason they haven't, says Finanz und Wirtschaft, is that the index is not a good reflection of the economy. The finance sector, full of damaged banks, comprises 20% of the index, compared with 5% of the economy. The energy sector is also over represented. Goldman Sachs has calculated that if the index mirrored the economy exactly, profits would have grown by 5% in 2015, rather than shrunk by 2%.

Another key point is that European firms have had trouble growing margins since the crisis, largely because the lacklustre environment has robbed them of pricing power, while labour costs have risen, says Barclays. The euro has also risen in the past year. But now the "drag on European earnings may finally be coming to an end", says Richard Barley in The Wall Street Journal.

Companies are getting labour costs under control, reckons Barclays, which bodes well for margins. The hit from the commodities collapse is fading, while an uptick in emerging-market growth should help too, since European firms are heavily exposed to emerging markets.

Eurozone domestic momentum, meanwhile, has been surprisingly good of late. Throw in low earnings expectations, a still-supportive central bank and reasonable valuations, and European stocks could well find their feet again.

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