Filed under: Weekly Market Commentary

Tiptoe Through the Tulips

and other European offerings - LPL Financial Research

Written by Boone Wealth Advisors

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The case for increasing European investments is getting stronger, as we evaluate the fundamentals, valuations, and to a lesser extent the technicals. Throughout most of the region, we are seeing improvement in the economic data and most importantly, in corporate earnings. After a strong fourth quarter 2016 based on MSCI Europe earnings up 28%, earnings growth may be positive for the first time since 2013, albeit just barely, on a year-over-year basis. More importantly, earnings expectations for 2017 have been improving. Valuations for European stocks are relatively attractive based on forward-looking earnings estimates, though they still seem expensive based on trailing earnings. The technical picture, the last components in our investment process, is decidedly mixed. On an absolute basis, European equities appear to be close to breaking out. However, relative to U.S. stocks, European equities have stalled, at least temporarily. Much of the relative performance between U.S. and European equities will likely depend on currency markets, which in turn are likely to be largely driven by political actions in both regions.

I LOVE PARIS (AND MADRID AND ROME) IN THE SPRINGTIME

In many parts of the country, we have not had much of a winter and are already several weeks into spring. Early season flowering trees and bushes are already in bloom; tulips cannot be far behind. Yet there is a sense of unease, that this is just too early and that a late frost could undo all the recent growth in one night. We have that same feeling about Europe. Sure, the economic fundamentals have been improving and corporate earnings are poised for their first increase since 2013.

Yet something still feels amiss. Europe has not solved many of the issues that have plagued it for almost a decade. The Greek debt crisis is still with us, though most agree it has been isolated such that a major default will not trigger a systemic crisis. Brexit—the U.K’s plan to leave the European Union—isn’t even official yet, with the two sides touting its probable impact as anything from a net positive for the U.K. to an economic apocalypse. As is nearly always the case, we suspect that the truth lies somewhere in the middle. Populism is now a major force in European politics, with three major elections this year (the Netherlands, France, and Germany), and a fourth (Italy) a possibility. The unknowns surrounding the outcomes of these events make it difficult for the markets, and LPL Research, to become too bullish on Europe just yet.

FUNDAMENTALS ARE BLOOMING

We cannot repeat it often enough; ultimately it is corporate earnings that drive stock prices. European earnings, at least in U.S. dollar terms, had been in absolute decline for the past three years. However, strong results for corporate Europe for fourth quarter 2016 thus far (not all companies have reported earnings) are suggesting that the earnings growth drought may be over. After a strong fourth quarter, European earnings for the whole of 2016 are tracking to an increase of 1.3% over 2015, the first year of growth since 2013 [Figure 1]. Even more importantly, consensus earnings expectations for 2017 are not only strong at just over 16% growth, but have continued to rise as earnings reports come in and economic data are released in the first two months of 2017.

Overall, about 54% of European companies have had a positive earnings surprise, averaging 3.7% in the fourth quarter. Of course, growth is not uniform and there are always surprise winners and losers by country and sector. There has been an earnings turnaround in sectors typically considered highly economically cyclical, such as materials and energy.

Materials companies’ earnings had a strong rebound in 2016, particularly in the fourth quarter. Energy sector earnings declined over the year, but like materials companies, posted earnings growth in the fourth quarter of 2016. However, both sectors have shown earnings disappointments; despite the growth experienced, global investors were expecting greater earnings gains for the year. Both sectors are expected to show significant earnings gains in 2017.

The financial sector is key for European equities. Financials, at about 20%, are the largest component of the major European indices. Furthermore, financials are the sector most likely to be directly impacted by the results of the Brexit negotiations, keeping in mind that the final decision on what the financial sector looks like post-Brexit is years away. However, the ability of U.K. banks to operate in the EU post-Brexit, a process referred to as “passporting,” is likely to be one of the most contested provisions of the final agreement, and one with a material impact on banks and bank earnings. Thus far fourth quarter 2016 earnings growth from the financial sector has been strong on an absolute level and relative to expectations.

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Written by Boone Wealth Advisors

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