Subdued earnings threaten European equity rally

October 4, 2013

* Profit warnings spark concern before Q3 earnings

* Cyclical stocks seen falling most on poor results

* Tech, semiconductors, autos the most shorted sectors

By Tricia Wright

LONDON, Oct 4 (Reuters) - A batch of profit warnings from European companies bodes ill for the third-quarter earnings season, which could erase the region's equity market recent outperformance over the United States.

The STOXX Europe 600 index rose around 9 percent in the July-September quarter, beating the S&P 500's near 5 percent gain as European economic data picked up just as uncertainty over U.S. monetary policy and spending surfaced.

Profit warnings over the past two weeks from consumer goods group Unilever and cruise operator Carnival, among others, have dampened expectations for stronger earnings, which investors had been counting on to keep Europe's equity rally on track.

Top-rated analysts see STOXX Europe 600 third-quarter earnings per share falling 6.6 percent year-on-year, against a 4.6 percent rise seen for the S&P 500, according to Thomson Reuters Starmine SmartEstimates data.

Analysts have trimmed their 2013 earnings estimates for the Euro STOXX 600 by 3 percent since the start of the third quarter, with cyclical sectors seeing some of the sharpest downgrades, according to Thomson Reuters Datastream.

Earnings estimates for the S&P 500 have been cut by only 0.3 percent.

The downgrades have not halted the equity rally, mainly because monetary stimulus from global central banks has supported share markets. That has helped drive the S&P 500 up 17.7 percent in 2013 and the STOXX Europe 600 up 10.7 percent.

Stocks in sectors like autos and miners, which are exposed to the economic cycle, could prove the top casualties since they rose strongly in the third quarter and because downbeat earnings may cast doubt over the vigour of the recovery.

European equities surged at the start of September as strong purchasing managers' surveys suggested business activity was rebounding. But analysts highlight a possible lag between an improvement in fundamentals and corporate earnings.

After a weak start to 2013, companies had been relying on a pick-up in the second half to boost their full-year numbers.

"Either they've got to make the numbers and keep the full-year guidance or say 'there's no way we're going to make that number' and have to bring it down ... I think this year we're in a situation where the fundamentals are not going to come through," BTIG strategist Nick Xanders said.

He reckons that if earnings estimates are realised, U.S. shares will tread water in the coming months given the government shutdown, while European equities will weaken, wiping out their recent outperformance.


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The reporting season in Europe gets under way in earnest in the week starting Oct. 21, trailing U.S. reports which kick off with numbers from aluminium producer Alcoa on Oct. 8.

"The profit warnings ... are just a reminder that we're not out of the woods yet, and valuations still have to reflect that - maybe the move that we've seen in the last few months is pricing in the good news a bit too early," Peel Hunt equity strategist Ian Williams said.

Analysts predict earnings per share growth of just 0.2 percent for 2013, against 9.9 percent at the start of the year, continuing a theme of the last two years when forecasts were also progressively downgraded, Datastream shows.

The gains in European markets make share prices more vulnerable in case of potential earnings' misses.

The STOXX Europe 600 is trading on a 12-month forward price/earnings ratio of 12.9 times, according to Datastream, with the S&P 500 on 14.2 times.

"If you do disappoint, you are going to see a pull-back with valuations having gone up a good deal," said Richard Champion, chief investment officer at Sanlam Private Investments (UK) Ltd.

"If you look at the sectors which have shown relative strength in Europe - banks, airlines, industrials, autos - for me those are the ones that are the most exposed to significant downside."

Technology and real estate are the most expensive sectors in Europe, trading on respective 12-month forward price/earnings ratios of 19.7 times and 18.4 times, Datastream shows.

There are signs investors are wary of some sectors. The tech hardware, semiconductor and auto sectors are being targeted by short sellers, with 7 percent, 3.8 percent and 3 percent respectively of shares on loan, Markit data shows.

"Earnings ... will be difficult and therefore the market is likely to have a turbulent period and some correction," said Stan Pearson, head of European equities at Standard Life Investments.