The European ISHARES STOXX 600 (EPA:SXP) index earnings could grow as much as 4 percent in 2013 and 12 percent in 2014, according to Barclays’ analysts. This compares to earnings declines experienced in 2012 and consensus expectations for flat earnings in 2013. In Barclays PLC (ADR) (NYSE:BCS) (LON:BARC)’s view, European earnings are at a cyclical trough and momentum can pick up from this stage. Hence, European equities could outperform U.S. stocks in the next 2 years.

European Central Bank

European earnings at a cyclical trough

Why are European earnings at a cyclical trough? Barclays analysts used Kalecki’s framework, back-tested to the 1950s, to answer this question. Kalecki’s formula calculates corporate profits as a percentage of GDP as follows:

Profits = Investment + Government Deficit – Household Savings – Foreign Savings + Dividends

Broadly, the factors can be explained intuitively as follows:

Investment: An uptick in investments helps increase the aggregate profitability of all firms within the economy. If one firm invests in assets, it is generating business for other firms within the economy, thereby boosting earnings.

Government Deficit: Acts as an aid to corporate profits, as the government’s transfer payments like unemployment benefits and higher subsidies benefit firms who sell more of their product thanks to these incentives.

Household Savings:  This factor acts as a headwind to corporate profits. As savings per household grow as a percentage of wages, wages spent decline, driving lower profit margins. Conversely, a low savings rate helps drive corporate earnings.

Foreign Savings: Quantified as the current account surplus or deficit, measured as the net payment to foreigners through trade. If there is a current account deficit (high foreign savings), more funds are paid to foreign entities and profitability at the local economy declines.

Dividends: Paid to households by corporations, this income could be recycled back into the economy, boosting corporate earnings.

Kalecki’s framework

Kalecki’s framework helps explain lower corporate profits in Europe for 2012. Investment declined and fiscal deficits shrank as a result of the sovereign debt crisis hindering profit expansion. In contrast, U.S. equities received support from the government as fiscal deficits doubled after the 2008 financial crisis, boosting earnings. Higher consumer spending, which in turn resulted in lower savings rates, also provided a tailwind for margins. More recently in the U.S., the fiscal deficit has declined thanks to budget cuts through sequestration, but an uptick in investments and continued consumer spending has helped neutralize the negative effect on profits of shrinking government spending. U.S. profit margins are still near all-time highs, and a further upside is unlikely, in Barclays PLC (ADR) (NYSE:BCS) (LON:BARC)’s view.

European equities Profit margin

European equity profit margins

In contrast, European equity profit margins appear to be reaching a cyclical low. Factors in Kalecki’s framework bode well for a profit upside in Europe as business confidence stabilizes and austerity measures shrinking government spending are contained. Higher business confidence could drive more investment, and more accommodative fiscal policy may facilitate further business investment and consumer spending. As consumer confidence recovers, the domestic savings rate could decline and the improvement in consumer spending will likely increase revenues and profits for businesses. Continued European export growth to the U.S. and emerging markets helps lower the foreign savings rate and support profit growth. Dividend growth rates are also close to 35-year lows, and Barclays’ analysts postulate that a return in business confidence could prompt businesses to increase dividend payments. In turn, dividends could be spent in the economy, thereby supporting profit growth.

Kalecki's framework European Equities