Friday, March 12th, 2021

Europe Has Second Thoughts

This is a follow-up to our previous note (The Pandemic Isn’t Over Yet, 26th February) where we noted that the Covid infection rate in the EU was starting to rise. We argued that this would quickly overturn the view that that the long end of the yield curve could rise with hindrance in the US and Europe. Since then, the rise in per capita infections has accelerated in the EU, while it continues to fall in the US. If current trends continue, the European infection rate will be twice that of the US sometime next week.

We don’t think that these trends will continue for very long because they automatically create a behavioural response: accelerated re-opening plans in Texas and other states and more stringent local lockdowns in parts of Italy and France. The point is that the infection rates very quickly feed into economic activity and financial markets. We note that the selling pressure in 10-year US Treasuries has eased significantly, and that the ECB has pledged to increase its monthly purchases of Eurozone government debt. We think there may also be an impact on European earnings estimates, which is our topic this week.

One of our lockdown projects has been to apply our probability approach to consensus earnings estimates, mainly because we wanted to prove that prices are a better indicator of future returns than fundamentals (which they are, but more of that later). However, one by-product of this is that we now have a very detailed data set covering rolling 12-month forward earnings estimates, which we can play around with. We normally calculate the probability that the earnings estimates of a particular industry group will rise faster than those of the index on a risk-adjusted basis, but we can just as easily ask whether they will beat a fixed rate, which we have set at 0% just to keep things simple.

Unsurprisingly, there is currently a 100% probability that the earnings estimates for the index of Europe ex UK, will higher in 12-months’ time than they are now. It was 0% between May and July 2020, after which it started rising in a straight line till it reached 100% in December, where it has stayed ever since. However, when we look at individual industry groups, the picture is not quite so rosy.  The average score for the 45 industry groups we cover is now 81% – down from a high of 90% in mid-February. It’s still a very good score – the average since 2003 is 62% – but it has started falling, either because the estimates for a calendar 2021 are being revised down or because those for 2022 are not being revised up. This would imply that that there is no multiplier effect in Europe as consumers start to spend their nest-egg of involuntary savings – a complete contrast to what is forecast in the USA.

Tracking the average for industries as well as the aggregate score for the index is important for two reasons. First, the average tends to turn before the aggregate. It bottomed at 10% in early May, but had already recovered to 20% in mid-July, which is when the index score first rose above zero. Second, when the difference between the average and the aggregate starts to increase, investors need to be more careful about stock and sector selection.

First the good news, the following industry groups all have a score of 100%: Energy, Materials, Chemicals, Machinery, Electricals, Trucks, Building Products, OEMs, Commercial Services, Transport, Apparel, Autos, Internet Retail, Major Banks, Regional Banks and Semiconductors. There is still a judgment call about whether the current consensus justifies their current prices, but there is universal agreement that the next 12 months will be better than the last.

Now the bad news; the following industry groups have a score of less than 50%, starting with the worst: REITs, Personal Care, Food, Pharmaceuticals, Technology Services, Other Utilities, Telecom Equipment, Healthcare Services. On the balance of probabilities, the next 12 months will be worse than the last 12 months. In addition to these, there are also industries which have seen a very significant reduction in their score since the beginning of the year. They are Telecom Incumbents, General Retail, Candy and Alcoholic Beverages.

In terms of market timing, it is too early to run for the hills. Major European companies will continue to benefit from faster growth in the US and Asia. We have already seen a response from the ECB and further fiscal stimulus should not be ruled out if the European vaccination programme continues to run into difficulties. However, there comes a time when lower estimates for individual industries start to have a cumulative impact on the index as a whole.

In the recovery phase, the gap between the first uptick in the average probability score and index aggregate was about seven weeks. Given that the first serious downtick in the average score came in mid-February, that takes us to the middle of April. This is when European companies will be thinking about what guidance to give for calendar 2021, when they announce their Q1 results. Unless there is a significant improvement in the vaccinations and infections data, many of them will have to revise their guidance down.

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