Schroders
Outlook 2015: European Equities
By Rory Bateman, Head of UK and European Equities
November 2014

Monetary policy remains loose and QE remains a possibility in the
coming months, but governments need to do more to stimulate
aggregate demand

Corporate profitability should improve given the stable economic
environment with exporters benefiting from a weaker euro

European equities remain attractively valued versus their own history,
as well as compared to other regions and asset classes
Europe’s economic recovery has been unpredictable during 2014. It has been our view for some
time that the recovery would be protracted and uneven, and the recent data has done little to
contradict us. The sluggish macro environment does not mean all is doom and gloom in terms of the
outlook for European equities; on the contrary, we see equity market weakness as a buying
opportunity. Firstly, there are still measures the authorities can take to strengthen the economic
recovery, and secondly there are several other factors with the potential to support eurozone
equities over the coming year.
ECB actions are helping but governments also have a part to play
The main concern facing Europe is that low levels of inflation may turn into deflation. This is not a
new issue and we do not believe that the probability of deflation is high. The European Central Bank
(ECB) has already taken significant steps to ease credit conditions and boost growth in the
eurozone. Some of these measures – such as the purchases of asset backed securities - are only
just being implemented so their full impact is yet to be felt. Moreover, we see a high probability that
full-scale quantitative easing (QE) could be introduced if deflationary worries in Europe persist. Each
of the three QE programmes in the US sparked a period of strong upward momentum for the US
equity market and we would expect the response in Europe to be similarly positive for share prices.
That said, ECB President Mario Draghi has made the point on a number of occasions that the
central bank cannot do all the heavy lifting on its own. In order to create a sustained economic
recovery in Europe, the ECB also needs governments to take appropriate fiscal measures in
conjunction with structural reforms in order to stimulate aggregate demand.
1
2
In our view, Germany’s insistence on balanced budgets is laudable but a more flexible approach is
needed to respond to the reality of the economic cycle.
Stage is set for corporate earnings to improve
Another factor that offers a significant opportunity is the scope for earnings improvement in Europe.
Profit margins for eurozone businesses still lag far behind their US counterparts and closing the gap
could help deliver sizeable share price upside. As well as an improved backdrop in terms of credit
conditions, there are other factors that could provide a catalyst for an improvement in profits.
12 months forwards earnings per share
€
$
40
0
20
MSCI EMU (LHS)
Jun 12
5
Jun 09
60
Jun 06
10
Jun 03
80
Jun 00
15
Jun 97
100
Jun 94
20
Jun 91
120
Jun 88
25
MSCI US (RHS)
Source: Datastream, 30 September 2014
One of the most obvious results so far of the ECB’s looser monetary policy has been the weakening
of the euro. The strength of the currency was a major headwind for eurozone equities, particularly
exporters, in the early part of 2014. That headwind has now eased and the currency is likely to
weaken further, especially with the US Federal Reserve poised to raise interest rates next year. The
weaker euro should be a source of positive earnings momentum in 2015.
Banks offer strong recovery potential
The banking sector is one important area where we see the potential for significant improvement in
terms of profits. Banks have been subject to myriad pressures, most notably with regard to potential
recapitalisations. The ECB’s recently-concluded Asset Quality Review has demonstrated that the
worst is over from that respect and banks should now have the confidence to return to lending. We
would expect European banks to emulate the recovery already seen in the profitability of US banks.
As lending growth picks up, our forecasts indicate that banking profitability will escalate quite
substantially over the coming three to five years, leading in turn to a significant positive impact on
net income.
3
European banks net income € billion 2007-2017e
140
120
100
80
60
40
20
0
-20
-40
-60
2007
2008
UK
2009
Nordic
2010
France
2011
2012
Germany
2013
Switzerland
2014e
2015e
Spain and Italy
2016e
2017e
Other
Source: Schroders estimates, top 29 listed European banks, as of August 2014 Europe remains attractively valued
There is also the impact that fund flows could have in the eurozone. While flows have improved
since the nadir of the eurozone crisis, we are still some 40% off the levels reached during 2001-07
so there is still a substantial amount of money on the side-lines that could potentially make its way
back into European equities. Moreover, we believe that current valuation levels would tend to
suggest that European equities remain an attractive area in which to invest. The pan-European
market trades on a cyclically-adjusted price-to-earnings ratio of around 16x, compared to the 30year average of 20.8x and to the US market on around 27x. We feel that represents a very
compelling opportunity.
Important Information:
Important Information: The views and opinions contained herein are those of Rory Bateman, Head of UK
and European Equities, and may not necessarily represent views expressed or reflected in other Schroders
communications, strategies or funds.
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