JPMorgan, however, thinks that there might be good reasons to view these assumptions as somewhat optimistic.
In 2005 European profit margins widened by an impressive 12%, more than at any time including 2000, when the figure was “just” 11.6%. This was helped by supportive factors including accelerating top-line growth, restructuring potential, low depreciation rates, low interest rates and a weakening currency. Analysts are expecting an average widening of a further 70 basis points this year for all sectors except energy. In other words, the consensus expectation is that as many as 71% of MSCI Europe constituents will have further ebit margin expansion in 2006 even though only 61% of corporates managed it in 2005, starting from a lower base.
But the effect of increased capital expenditure last year is likely to be felt this year in the form of increased depreciation, which will put a drag on earnings.
Moreover, although in the US the Federal Reserve waited for growth to move above trend for four quarters before beginning to raise rates, the ECB has already started tightening, before any sign of an improvement in growth. Rising interest rates put valuation multiples under pressure and tend to subdue equity performance.
European equities have been boosted by the perception that they offer better value than US equities. But although this might have been true last year, the discount relative to US equities has narrowed and it is now roughly in line with the long-term average.
On a price to earnings growth ratio, European equities are now trading at more than one standard deviation, which is expensive relative to US equities.