European Equity THE EUROPEAN EARNINGS SEASON CONFIRMS CORPORATE RESILIENCE

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1 PRICE POINT April 2017 Timely intelligence and analysis for our clients. European Equity THE EUROPEAN EARNINGS SEASON CONFIRMS CORPORATE RESILIENCE KEY POINTS Dean Tenerelli Portfolio Manager, Europe Equity Strategy The recent earnings season, now drawing to a conclusion, confirms an optimistic outlook for European earnings growth. In recent weeks there has been a modest upward pressure on estimates for European earnings growth this year, with consensus expectations now standing at around 14% in The resilience in market earnings forecasts is in sharp contrast to the pattern seen in recent years. In each of the past five years ( ) consensus estimates have declined materially in the first quarter. In each case, estimates continued to be reduced through the rest of the year. There has been a dramatic rotation in the European market in the last 12 months or so, presenting investors with a range of new opportunities but also potential risks. We continue to deploy capital in better-quality companies in areas of the market where our valuation signal suggests an attractive risk/reward trade-off. If earnings growth is realized this year and beyond, then this should give investors greater confidence about the valuation opportunity that exists in European equities. The recent earnings season, now drawing to a conclusion, confirms an optimistic outlook for European earnings growth. Analysis 1 highlights that earnings in the most recent quarter grew by 10%, with more companies surprising positively than negatively. There was a good breadth to this performance, with earnings in all but one European market sectors advancing (10 of 11, with energy the exception). Although investors appear to be more focused on the potential for further earnings growth in the U.S., the advance in that market was a lesser 5%. Furthermore, in recent weeks there has been a modest upward pressure on estimates for European earnings growth this year, with consensus expectations now standing at around 14% in In comparison, expectations in the U.S. have slipped from the start of the year, with a lower rate of growth now expected than in Europe. 1 Source: J.P. Morgan, as of March Source: FactSet, as of March 2017.

2 Local, December Figure 1: European earnings estimates in 2017 A sharp contrast to recent years EPS Estimates Through Time, Percent, Year-on-Year 20% % 10% 5% 0% -5% -10% Sources: Morgan Stanley and FactSet, as of February Past performance is not a reliable indicator of future performance. The resilience in market earnings forecasts is in sharp contrast to the pattern we have seen in recent years. Figure 1 demonstrates how consensus estimates have declined materially in the first quarter for each of the last five years ( ) with growth estimates reduced by an average of four percentage points in the first quarter in that period. In each case, estimates continued to be reduced throughout the rest of the year, and the overall path of earnings was disappointing over a sustained period. Figure 2 confirms that as a result, earnings in Europe are still materially below the level achieved 10 years ago, whereas there has been a sharp recovery in the U.S. Figure 2: European earnings still have some way to go Earnings Per Share Relative to History MSCI Europe 50 S&P MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. This erosion was caused by a number of factors, to varying degrees. A very sluggish domestic economy more than expected has been a consistent drag. Slower-than-expected growth in emerging markets and, to a lesser extent, the U.S. has been a constraint in recent years. The collapse in commodity prices in PRICE POINT 2 2 2

3 P/E Ratio dramatically undermined the results of most components in the energy and materials sectors. A consistent headwind has also been the structural downward shift in the earnings of the financials sector, due to the challenges of greater regulation, disruptions to business models, and very low interest rates. My style of investment is more focused on identifying longer-term fundamental strengths of businesses, rather than short-term earnings momentum. However, I also look for a pattern of predictability in performance, which is a natural by-product of a good-quality company. In addition, as I seek to ensure that the portfolio is appropriately balanced, I look for it to perform in a range of market conditions. The current environment continues to be one marked by hopes of reflation and better global growth, as reflected in valuations of some cyclical areas of the market. So I have been reassured by the overall operational performance of the companies in the portfolio. In aggregate, the reported results of my holdings were close to expectations, and there has been a modest upward movement in earnings estimates for the current year. Uncertainties remain about the path of the economic cycle and, in some of those cyclical parts of the market, what could prove to be optimistic medium-term scenarios, in my view, are being discounted. But the economic fundamentals do appear to be improving in Europe, as evidenced by hard data and surveys such as purchasing managers index (PMI) readings. HOW ARE WE PLAYING THIS BACKDROP? There has been a dramatic rotation in the European market in the last 12 months or so, presenting investors with a range of new opportunities but also potential risks. We continue to deploy capital in better-quality companies in areas of the market where our valuation signal suggests an attractive risk/reward trade-off. At the margin we are finding more of these opportunities in more defensive areas, such as in telecoms and regulated utilities. This is being balanced by our increased exposure to financials specifically, well-managed franchises in consolidating markets which we expect to benefit from changes in expectations about inflation, interest rates, and growth. Figure 3: European valuations remain low versus history and other developed markets Cyclically Adjusted Real Price-to-Earnings (P/E) Ratio Europe (Avg = 19.5) USA (Avg = 23.9) Japan (Avg = 43.4) PRICE POINT 3 3 3

4 P/E Ratio Figure 4: European valuations based on next 12 months expected earnings Price-to-Earnings (P/E) Ratio (Next 13 Months) Europe (Avg = 13.7) USA (Avg = 15.5) If earnings growth is realized this year and beyond, then this should give investors greater confidence about the valuation opportunity that exists in European equities. Figure 3 shows that on a normalized, cyclically adjusted basis (using the average of the last 10 years of earnings), the European market is still on a relatively low rate versus its own history, and also versus other developed markets. Using expectations for the next 12 months, as depicted in Figure 4, the European market may be trading at a slight premium to its longer-term average. But further positive earnings momentum should help to bridge the gap, and provide support. PRICE POINT 4 4 4

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