Industry Voice: Differentiation will be the key

Summary

• We believe that investors in European Equities could be set for a strong 2016

• On the surface 2015 was a bad year for corporate earnings, however the underlying numbers for 2015 were not as bad as headline figures suggested and 2016 could see further improvement

• Investors need to be active and differentiated to succeed in 2016

Compared to equity markets around the globe 2015 was a good one for equities in Europe. Differentiation was key, and investors were forced to differentiate in their stock selection in a market that saw both dispersion levels increase, and unusually large sector return divergences. On a single stock basis this meant avoiding the likes of Glencore, Volkswagen, and Rolls Royce, while more broadly commodity and emerging market exposed stocks sold off as global growth data disappointed.

The need to differentiate

We retain our core view that European equity markets can move markedly higher, but that returns should be driven by meaningful earnings growth rather than further re-rating. Valuations are now at fair levels (although Europe looks cheap relative to other developed markets, particularly the US), meaning that beta returns are likely to be lower than we have seen in Europe since July 2012. This combined with reduced systematic risk in Europe, should ensure that it becomes increasingly important to again differentiate through stock selection, with inter-sector return dispersions likely to increase further. It will be vital to identify those companies able to generate visible and structural earnings growth in an environment where global growth remains unclear. We believe that over the cycle it is this earnings and cash flow growth that will continue to act as one of the main sources of shareholder returns. This is clearly supported by the almost perfect correlation between the long term alpha in our funds (7%
p.a. over the last ten years), and the 7.2% excess earnings growth we have generated per annum over and above the European market¹.

With 0% earnings growth in Europe, 2015 was again a year of earnings disappointment at the headline figure. The reality is however less gloomy, with many sectors earnings recovering, as the majority of downgrades were driven by commodities, where earnings expectations were cut by 45%. Excluding the commodities sector, the European market grew earnings by 8%, with our funds earnings having grown by c. 13%. Consensus expectations for 2016 have come down though, which leaves room for surprises to the upside, unlike in previous years where consensus started too high.

_{Source UBS, Global Research, January 2016.}

We do, however, see reasons why 2016 may prove a better year for European earnings. Firstly Europe clearly should benefit from ‘catch up potential,' with earnings having not grown since 2011, and having significantly underperformed the US. Secondly European companies will benefit from operating leverage.

European net income margins are still depressed at 5.7% (3% below the US) but finally rising, and still far below the previous cycle peak of 8.4%. If, as we expect, we see a pick-up in nominal GDP growth, and with many corporates benefitting from lower input costs, margins should continue to expand. There are though undoubtedly risks to equities, as highlighted by the start to 2016 in the form of a further slowdown in China, the impact of US rate hikes, and the possibility of industrial data in the US weakening further.

From an economic perspective, Europe unusually appears one of the shining lights globally, with positive PMI's, and sentiment all suggesting that a reduction in the fiscal drag, supportive monetary policy, improved financial architecture, and a weaker euro have improved the competitiveness of the Eurozone.Therefore while the exceptionally high beta led returns of the previous four years in Europe may be ambitious, we believe that currently Europe arguably looks the most attractive equity market globally. With stock picking likely to be increasingly influential in total returns, we hope that 2016 can once again be a profitable year for our investors.

¹Allianz Global Investors as at 18/01/2016.

^{Investing involves risk. The value of an investment and the income from it may fall as well as rise and investors might not get back the full amount invested. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer companies at the time of publication. The data used is derived from various sources, and assumed to be correct and reliable, but it has not been independently verified; its accuracy or completeness is not guaranteed and no liability is assumed for any direct or consequential losses arising from its use, unless caused by gross negligence or wilful misconduct. The conditions of any underlying offer or contract that may have been, or will be, made or concluded, shall prevail.}

^{This is a marketing communication issued by Allianz Global Investors GmbH, www.allianzgi.com, an investment company with limited liability, incorporated in Germany, with its registered office at Bockenheimer Landstrasse 42-44, 60323 Frankfurt/M, registered with the local court Frankfurt/M under HRB 9340, authorised by Bundesanstalt für Finanzdienstleistungsaufsicht (www.bafin.de). Allianz Global Investors GmbH has established a branch in the United Kingdom, Allianz Global Investors GmbH, UK branch, 199 Bishopsgate, London, EC2M 3TY, www.allianzglobalinvestors. co.uk, which is subject to limited regulation by the Financial Conduct Authority (www.fca.org.uk). Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. 16-1054}

Contact details
Email: [email protected] Web: www.allianzgi.co.uk Telephone: [phone] Address: Allianz Global Investors GmbH, UK Branch, 199 Bishopsgate, London, EC2M 3TY