European equities: making sense of gloomy markets
Key takeaways
Our team’s approach is to find companies which have the potential and willingness to change for the better. We find markets struggle to value companies undergoing change or what we call transition, providing lots of valuation anomalies to exploit.
Markets are currently clearly grappling with lots of changes, for example high inflation and rising interest rates – and what that could mean for the economy and corporate earnings. By better understanding what markets are pricing in, we’re better placed to understand valuation opportunities as they arise within the market. We’re now starting to see more economically sensitive companies profit warn, due to a combination of weaker than expected end-user demand and higher costs.
Kion and Electrolux are two examples, while SKF also talked about volume headwinds too. It’s hardly a surprise to the market, which has been fretting over rising economic headwinds and cost inflation for a while, resulting in European equities falling by 20% year-to-date on a EUR basis (or 31% on US$ basis).1 As is usually the case, earnings expectations haven’t yet been downgraded (consensus still expecting a bit of EPS growth in 2023), obscuring underlying valuations.
What are current market prices telling us about valuations?
That’s the key question we’re asking ourselves right now. Critical to answering this question is to assess what earnings could look like in a more challenging economic environment – and if the subsequent valuations look reasonable (or not).
To get closer to an answer, we’ve used a top-down model constructed by Morgan Stanley – using our assumptions – to indicate what earnings in 2023 could look like. Various inputs are required, including real GDP by region, commodities and FX. This generates an earnings number (E) for 2023. By applying current stock prices (P) to 2023 earnings, we can then calculate a market PE ratio and compare this multiple to the long-term average.
It's worth pointing out that this model provides a useful guide to future earnings, but it doesn’t necessarily capture all the relevant influences/drivers. There’s also an assumption that the model, based on historical correlations, works just as well in a high inflation environment as it has done in the prevailing disinflationary world of the past decade. With the model relying on real GDP as a key input, we wonder if high inflation is properly captured in earnings.
Likewise, the impact from rising government bond yields on earnings could be underappreciated for interest rate sensitive sectors, such as banks. To us it’s rational to expect higher bank earnings in 2023 than what bottom-up analysts are forecasting – even in a more challenging economy. In our view, this effect is not fully incorporated in such a model either.
Our assumptions in estimating 2023 earnings
Economy: Outside of the Eurozone we use economists’ consensus GDP forecasts. For Eurozone we incorporate a more bearish economic outlook. Why? As it stands today there’s a big gap between higher energy costs to be absorbed by households/corporates (5% of GDP) and the assistance being provided by national governments (3% of GDP).
European policymakers announced additional support last week, worth around 1% of GDP. More help, nationally and/or at a European level, can’t be ruled out either. Conservatively, we put in a real GDP2 contraction of 1% in 2023, (broken down as a 2% GDP decline in H1 followed by flat year-on-year in H2). This compares to consensus of approaching +1% today.
Commodities: We’re using forward prices as assumed in bottom-up analysts’ forecasts. These tend to be lower than average prices so far this year.
FX: Given the volatility of currencies, we’ve assumed current spot rates going forward.
What does this imply for 2023 earnings?
Overall, this points to a year-on-year contraction in earnings per share (EPS) of up to 20% in 2023. We believe this is much more realistic than what consensus is currently assuming – a small increase overall. That said, the model could penalise sectors like banks, which are still likely to grow earnings next year as rates are going up. This could mean earnings do better than what’s being implied by the model.
What do this scenario mean for valuation at a market level?
At the end of September, the MSCI Europe index was on a 2022 PE ratio of around 11x. A 20% fall in earnings in 2023, as indicated by the model, translates into a PE ratio of around 14x for 2023. In other words, a PE ratio not too dissimilar to the long-term average of 14-15x.
In short, markets are broadly pricing in a recession for next year, which means the resulting valuation looks about right. It’s neither cheap nor expensive relative to history, at the aggregate level.
What about at a sector level?
When considering individual sectors, markets appear to be heavily penalising specific areas. To be clear this is using current sector earnings expectations. For example, energy and materials are on a 2023 PE of 5x and 10x (less for the names we own) and are already baking in steep falls in earnings of between 15-20%. In other words, there’s an awful lot of bad news already assumed in earnings and valuations.
Banks are trading on a historically very low PE of 7x yet are one of the very few sectors still seeing earnings upgrades. Importantly, they are well-capitalised today, providing significant protection to a worsening macroeconomic environment.
Risk or opportunity?
To us, the current valuations of these sectors can only be justified, if the outlook deteriorated significantly from here – much worse than the level of GDP we’ve assumed in the above scenario. Even if the outlook took a significant turn for the worse, it’d be wrong to assume that policymakers, both at a national and EU level, would idly sit by either.
Don’t forget: in response to the pandemic, policymakers loosened the fiscal rules, while creating the recovery fund – a significant long-term investment plan. Below shows the sector PE ratios as of today versus their 10-year history.
Source: Goldman Sachs Global Investment Research, Stoxx Europe as at 20 September 2022.
Opportunities amid headwinds
The key for us is valuation – what’s already in the price and what prices are ignoring. We’re always thinking about what a company should look like in the future, and the measures being put in place to get there.
Markets are currently very much focused on economic headwinds, penalizing specific companies and sectors. Much less emphasis is being put on medium-term structural drivers and company specific strategies, which are key in companies changing for the better.
This is providing us with opportunities – and in some cases at compelling valuations – due to the recent de-ratings.
