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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is head of European equity strategy and head of global derivatives strategy at UBS
In the 15 years from the financial crisis in 2007 to the bond shock of 2022, the trend of equity outperformance of the US over Europe was stark.
Total returns from US equities over that period were 6 per cent a year above those for European equities. Rising yields, however, have recently levelled the playing field.
For a brief period earlier this year, if felt safe to buy European equities again. Despite their growth and quality, expensive US growth stocks had underperformed more cyclical European companies. In one stunning example, European banks have outperformed the Nasdaq index by 71 per cent since that electrifying week in late 2020 when successful Covid vaccines were announced.
Europe started the year garnering global attention as a significant majority of companies beat analyst estimates for first-quarter profits. Perhaps this was a consequence of expectations lowered by the winter energy crisis. Since then, hopes have been dashed. From the moment the second quarter began, Europe experienced consistent negative economic surprises. Second-quarter results were more mixed, with only about half beating market expectations — the lowest “beat” rate since before the Covid-19 pandemic.
The third quarter has turned out to be a continuation of those trends. Hard data, like retail sales, turned negative. Soft data, reported in purchasing manager surveys, were weakening sharply. And now, companies like Worldline are shocking the market by reporting an outright decline in nominal spending through their terminals in Germany. Disappointment is increasingly widespread as we progress through the third-quarter earnings season. Outlook statements by companies highlight risks that extend into 2024.
Three dominant factors driving corporate profits are volumes, pricing power and cost structures. In Europe, most companies are now facing pressure in at least one of these areas. Industrials and autos have been reporting weak new orders for more than a year, but more recently are also reporting a decline in their backlogs of work.
This points to imminent earnings risks, with Renault and ABB being recent high profile examples of companies that have disappointed investor expectations. Airlines and autos are highly competitive sectors with limited pricing power. Rising wages and oil prices compound the pressure for companies most exposed to labour and energy. In essence, demand is weakening and margins are at risk.
Margins are almost always procyclical. When growth is improving, margins expand, and when growth decelerates, margins compress. This typical business cycle is already under way but for the Stoxx 600 index, margins remain well above pre-Covid levels. Sales growth may be resilient as real wages rise. However, if margins were to retrace merely to 2018 levels, earnings in Europe will fall by double-digit percentage points. Margin resilience is going to be a defining characteristic of winning stocks next year.
Bond yields matter too. The sharp rise in interest rates in the past two years has not just affected the valuation investors are willing to pay for equities, but increasingly the profitability of more indebted companies as well. Higher yields and margin pressures mean investors are already rewarding companies with more robust margins and lower leverage. The “quality” factor is outperforming again for the first time since before Covid and we think this will continue.
Quality comes at a price. Higher quality companies regularly trade at a premium valuation and it is no surprise that a stock like Novo Nordisk, among the highest “quality” in Europe, now trades on 30 times consensus earnings that themselves are expected to grow much faster than the broader market. This is pretty expensive compared with the 12 times ratio for the Stoxx 600 and earnings growth in single-digit percentage points.
Capturing a broader range of inputs means seeking quality that trades at a reasonable valuation, with favourable earnings momentum and investor positioning. Companies that match this criteria include GTT, Inditex, Relx, Ipsen and Hermes.
The business cycle is rolling over in Europe. Demand is weakening and margins are at risk. High yields are pressuring weak balance sheets. 2024 is likely to be a year when investors reward resilience in the face of these factors. A year when quality reasserts its value to investors. It may not be all that safe to buy European equities until we are closer to a new business cycle recovery but there are stocks we think resilient to the mounting pressures on corporate profits.
