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Franklin Templeton: How inflation could rescue eurozone earnings

09 February 2017

Dylan Ball, executive vice president and portfolio manager within Templeton Global Equity Group, gives his outlook on inflation in Europe and the impact on corporate earnings.

By Dylan Ball,

Franklin Templeton Investments

After a year in which political surprises dominated headlines across the globe, we believe conditions are lining up for a positive year for European equities—and not before time. 

Recent experience suggests that equity markets in general have a problem pricing in political events. However, we believe politics does not drive equity markets over the long-term; rather, it provides a short-term opportunity to take advantage of longer-term trends.

As value investors, we try to stay focused on a longer-term investment horizon and use volatility as an opportunity to look for undervalued companies.

A positive macro environment

A devalued euro, momentum in the credit cycle and the winding down of austerity across the continent are all considered generally positive for European equities.

More important for the asset class in 2017, we believe, is the prospect of higher inflation, which now seems likely to be coming down the pike. Inflation, in our view, should be positive for European earnings.

Traditionally, inflation has tended to lag movements in energy and commodity prices by approximately three to four months. By September last year, the price of oil had recovered from its historic lows, moving back up to around $50 per barrel.

European Central Bank Harmonised Consumer Prices over 2016

 

Source: FE Analytics

The effect of that price increase is now showing up in the inflation figures, suggesting to us that Europe could be moving from a 1-2 per cent inflation environment to perhaps a 3-4 per cent inflation environment.


How sustainable is the inflation story? 

We think a number of factors point to a sustained period of higher inflation across Europe.

Higher oil and commodity prices feature in our base case, as a number of important commodity prices seem to us to have shown signs of bottoming out in the second or third quarter of 2016. 

An increase in infrastructure spending in the United States and Europe would likely maintain that upward momentum. 

Oil prices remain supply driven. We don’t have a crystal ball, but our research and calculations suggest global demand for oil could support a price above the recent $55 per barrel level.

After all, demand for oil continues to grow at 1-2 per cent per year globally. While an increase in the US rig count might go some way to meeting demand growth, members of the Organisation of Petroleum Exporting Countries appear to be willing to restrict their output in order to push oil prices higher. 

Performance of index over 2016

 
Source: FE Analytics

Meanwhile, during recent research trips in Europe, we came across some evidence that the debate on stimulus is moving out of monetary policy and into fiscal. 

Some have suggested that if US President Donald Trump were to go down the fiscal leverage route, in which he starts spending and building, some European countries, such as Germany, might consider similar moves.

Furthermore, should the Trump administration press on with the more protectionist agenda that he advocated in his presidential campaign, that too could have an inflationary effect through higher import prices.

Why does this matter for European earnings?

The stubborn gap between US and European earnings has failed to close over several years. European earnings currently remain 60 per cent below some peaks during the 2008/2009 period, while US earnings are 10 per cent above levels of eight or nine years ago.


Observers have cited a number of possible reasons for this discrepancy, including a claim that the sort of monetary policy that the European Central Bank is pursuing cannot work effectively without fiscal unification.

Another suggestion is the positive earnings impact of share buybacks in the United States, where the tax regime has traditionally been supportive of such measures.

In our view, the overwhelming reason that European earnings continue to lag their US peers is that profit margins in Europe have not yet recovered in the way that one might hope.

It may be easy for observers to say that European labour markets are not as competitive as their US counterpart and can’t respond as nimbly to lower demand. However, we don’t think that is the case; labour costs in Europe have been very competitive, in our view.

Instead, we think the underlying issue is pricing.

European companies tend to be price-takers. When inflation falls, European firms tend to cut prices to compete with their US and Asian peers. When inflation rises again, European companies tend to raise their prices.

Therefore, once European companies respond to rising inflation, we’d expect a closure of the earnings spread with the United States.

Inflation: Good for Europe, good for value investors

We’ve been in a deflationary world the last eight to nine years. As a contrarian investor during that time, we’ve taken an interest in companies that fare well when there’s no inflation. Conversely, as inflation turns upwards, we believe for a rerating of industrials, financials, and oil and gas stocks in Europe.

And as we survey the landscape for European equities, it’s that rerating story that seems to us to offer an opportunity for long-term returns.

Dylan Ball is executive vice president and portfolio manager within Franklin Templeton Investment's Templeton Global Equity Group. The views expressed above are his own and should not be taken as investment advice.

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