The relative youth of the European earnings cycle versus the now long-in-the-tooth UK equivalent has been a key factor in the relative discount of domestic equity over the past year.
The FTSE All Share Index currently trades at a yield of 3.59% and a price-to-earnings (P/E) multiple of 14.71 versus 3.25% and 15.08 respectively on the STOXX Europe 600 index.
The prospect of stronger earnings (and, more importantly in the current environment, dividends) in 12 months’ time is worth the premium, runs the reasoning.
That perception still holds, even if some of the easiest assumptions made at the beginning of the year have been blown off course by the unexpected strength of both sterling and the euro. With UK earnings surprising to the upside, should you now repatriate profits and begin to buy Britain Plc?
In May, Deutsche Bank slashed its 2014 estimate of STOXX 600 earnings per share (EPS) growth from 12% to 7%, below its current estimate of the FTSE 100’s full-year EPS growth of 8%. The latter figure was issued at month-end, following a surprisingly resilient start to first quarter earnings.
Despite the strength of the pound, 56% of FTSE 350 companies that reported for the period beat their earnings expectations with an aggregate surprise of 1.8%.
While this was still below the 2.1% earnings growth of the STOXX 600 over the period, the direction of travel and its impact on forecasts for the remainder of the year might be more significant. Analysts had previously forecast 9% growth compared to the same period of the year before.
According to Reuters data, in late May updated analyst forecasts were pointing to a 1.2% fall in Continental earnings by the end of the reporting season. Deutsche Bank equity strategist Gareth Evans said: ‘The recovery in Europe is a double-edged sword and on the modelling we have done, we think you can attribute 50% of the earnings miss we have had to the strength in the euro.’
Global leaders and European bellwether stocks such as hotel group Accor, German software business SAP, luxury goods manufacturer LVMH and the world’s largest food business Nestlé have all reported currency as a major factor in disappointing Q1 results.
Nonetheless, Deutsche continued to recommend a higher conviction European weighting, saying the risk to its forecast remained more weighted to the upside, in particular the potential impact of the European Central Bank (ECB) moving closer to an outright monetary easing.
The second quarter will also arguably be more significant as an indicator of how euro corporates handle weaker-than-expected earnings.
‘With more than three fifths of European dividends paid in the second quarter, Q1 is relatively unimportant,’ said Henderson in its Global Dividend Index report in May.
High payouts but stronger earnings
While few investors would cheer the payment of uncovered dividends, Evans pointed out there was a historically high correlation between European companies that did so, and companies that then went on to report much healthier metrics in subsequent quarters.
‘Basically, companies will be comfortable in carrying a higher payout if they see the possibility of stronger earnings growth ahead of them,’ he said.
Focusing on the index level also ignored the relative diffusion of European dividend payments – a factor that could be considered both a blessing and a curse.
The spread of contributing companies presented challenges as it made it harder to capture yield beta, but also excluded the UK’s stock concentration risk, said Alice Gaskell of the BlackRock Continental European Income fund.
The top 10 dividend payers in the UK account for 56% of all dividend income Gaskell said, compared with just 23% in Europe. ‘We have avoided the areas of the European market where dividend risk is higher (such as banks), our investments in infrastructure and real estate have benefited both from an improving European economy and lower political risk.’
Speaking at a dinner to mark the launch of his independent fund business last month, Neil Woodford pointed out that single-stock dividend risk was rising sharply in the UK, with two of the biggest contributors, BP and Shell, under pressure from lower oil and higher exploration costs.
‘They are two very stressed organisations and I do not find them terribly appealing,’ Woodford said. ‘I will not own them until they are much better value than they are now.’