For many months, improving economic conditions in Europe have been reflected in financial markets, but not in companies’ bottom-lines. Finally, there are signs that this is changing.

Second-quarter results suggest that European companies are returning to positive profit growth after three years of declines. Meanwhile, the number of non-financial corporate debt defaults in Europe in the first three months of 2014 is lower than in any first quarter since the onset of the financial crisis in 2008.

These indicators are unlikely to be a flash in the pan. Growth forecasts for Europe’s economies have been revised up during the past few months, and consumer confidence is improving. Nevertheless, there are danger signs — some familiar, some new — that investors should note.

Although consumers are getting more cheerful, other data are mixed.

The purchasing managers’ index — a poll tracking economic activity in the Eurozone — reached a three-month high in July, well above the level that marks an expansion in activity. However, business confidence is less secure.

In Germany the Ifo index of business sentiment has had three successive months of falls, and France’s business climate index is well below its long-term average. Heightened geopolitical risk, as a result of the crisis in Ukraine, is not helping matters.

Other worries continue to niggle. Borrowing conditions in financial markets remain extremely easy, allowing Europe’s companies to take on loans or refinance old debt at record low rates.

One of the side effects of these benign conditions has been that corporate leverage in the euro-zone remains close to pre-recession highs. True, the nature of this corporate borrowing is less worrying than it was immediately before the crisis.

In 2006 and 2007 about half of all loans issued related to acquisitions or leveraged buyouts. In 2013, by comparison, loans supporting acquisitions and buyouts were only about 12 per cent of total loan issuance.

M&A activity involving European companies may have leapt — $373 billion (Dh1.37 trillion) year to date compared with $288 billion for the whole of 2013 — but so far, at least, it is not excessively financed by debt.

But while borrowing may not be fuelling the M&A boom, nor is it helping to boost European investment in future growth. Standard & Poor’s forecasts that capital expenditure will rise just 1.2 per cent in real terms this year and then fall next year, with US companies outspending their European rivals.

Easy credit conditions appear only to have benefited large, often listed, corporates. Smaller companies continue to have few funding options apart from banks — and bank lending to non-financial corporates has, almost unbelievably, been contracting for the past five years.

This means that companies in Europe’s periphery continue to be starved of credit. Corporate borrowing by companies domiciled in Greece, Ireland, Italy, Portugal, Spain has fallen from more than a fifth of the European total before the crisis to only 12 per cent now.

It is important to remember, as well, that the benign credit conditions have not been created by a healthy economic environment, but by its opposite: a financial crisis, followed by hugely accommodative monetary policy in response to it.

The artificial nature of this credit market is reflected in a renaissance of the more aggressive structured transactions seen in the 2006-07 boom. Leverage loan volumes — €45 billion in the first six months of the year — are at their highest level since the onset of the financial crisis.

This boom in volumes has been accompanied not just by a fall in spreads but by a revival of riskier covenant-lite lending, which places fewer conditions on borrowers.

One example cited by S&P is the proposed recapitalisation of Continental Foods, a Belgium-headquartered consumer food business. According to Thomson Reuters, private equity group CVC bought the group in October 2013 using €320 million of senior leveraged loan financing, and is planning to pay itself a €160 million dividend from the business, after a refinancing that will take Continental Foods’ debt-to-earnings ratio to about 5.7 times from a current level of 2.9. Reports suggest that the transaction will also remove all loan maintenance covenants.

Transactions such as these are still anomalies in today’s markets. S&P calculates that during the past 18 months private equity debt financing contributed only about 8 per cent of total European corporate primary loan and bond volumes. But their reappearance at a time when economic growth is still fragile should give investors pause.

— Financial Times