European equities: JPM queries the bullish mood
There is a consensus view that European equities are cheap and that M&A will continue to drive the market up and keep the liquidity flowing. This rosy vision is built on the assumption that earnings will remain strong, that global growth is re-accelerating, that the risk from inflation is minimal and that interest rates are therefore likely to remain low.
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.