European non-financials have had mixed fourth quarter results so far, but strong PMI and low wages suggest that sales and margin growth could be considerably stronger than consensus, and Barclay’s analyst Ian Scott tells investors to “keep faith in the fundamentals.”
“Incoming economic data strongly endorse our (and other economists’) recovery projections, yet the consensus for top-line revenues and bottom-line earnings is inconsistent with this outlook,” Scott writes.
PMI indicates strong GDP growth
The purchasing manager’s index (PMI) is a strong leading indicator for GDP growth, and it has moved up sharply in the last quarter, suggesting that Eurozone GDP should follow suit. Scott estimates that nominal GDP growth of 2.5% would drive stock prices up by 6%, compared to an International Broker’s Estimate System (IBES) estimate of just 2%, leaving plenty of room for upside even if GDP growth falls slightly short of his projection.
Margin growth may also beat consensus
“It is not just at the top line where we think the consensus is too low; margins are also likely to surprise on the upside,” writes Scott.
Wage growth is below the recent historical range in the Eurozone, and most analysts expect it to remain low at least in the short term. This low level of compensation has correlated with growing margins in the past, and while Scott doesn’t forecast margins anywhere near former peaks, he estimates that two years of non-financial EBITDA margin expansion will return margins to the historical average.
This is similar to the argument that Citi recently used to bump their GDP growth target for Spain from 0.2% to 0.9% for 2014, citing low wage growth as a driver of corporate profitability, which in turn has improved employment numbers. Citi analyst Giada Giani sees the potential for a similar dynamic to speed up the recovery in Portugal, and low wage growth is a factor in many Eurozone countries, not only on the periphery.
“If we are right on earnings the market multiple for nonfinancial companies should drop from 18 to 12.5 by the end of 2015,” Scott writes.
In other words, Scott sees European equities as being cheap right now because the consensus view is undervaluing their actual potential for growth.