Subdued earnings threaten European equity rally

Reuters

* 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 fromEuropean companies bodes ill for the third-quarter earningsseason, which could erase the region's equity market recentoutperformance over the United States.

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

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

Top-rated analysts see STOXX Europe 600 third-quarterearnings per share falling 6.6 percent year-on-year, against a4.6 percent rise seen for the S&P 500, according to ThomsonReuters Starmine SmartEstimates data.

Analysts have trimmed their 2013 earnings estimates for theEuro STOXX 600 by 3 percent since the start of the thirdquarter, with cyclical sectors seeing some of the sharpestdowngrades, according to Thomson Reuters Datastream.

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

The downgrades have not halted the equity rally, mainlybecause monetary stimulus from global central banks hassupported share markets. That has helped drive the S&P 500 up17.7 percent in 2013 and the STOXX Europe 600 up 10.7 percent.

Stocks in sectors like autos and miners, which are exposedto the economic cycle, could prove the top casualties since theyrose strongly in the third quarter and because downbeat earningsmay cast doubt over the vigour of the recovery.

European equities surged at the start of September as strongpurchasing managers' surveys suggested business activity wasrebounding. But analysts highlight a possible lag between animprovement in fundamentals and corporate earnings.

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

"Either they've got to make the numbers and keep thefull-year guidance or say 'there's no way we're going to makethat number' and have to bring it down ... I think this yearwe're in a situation where the fundamentals are not going tocome 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 thegovernment shutdown, while European equities will weaken, wipingout their recent outperformance.

BANKS VULNERABLE

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

"The profit warnings ... are just a reminder that we're notout of the woods yet, and valuations still have to reflect that- maybe the move that we've seen in the last few months ispricing in the good news a bit too early," Peel Hunt equitystrategist Ian Williams said.

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

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

The STOXX Europe 600 is trading on a 12-month forwardprice/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 withvaluations 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 relativestrength in Europe - banks, airlines, industrials, autos - forme those are the ones that are the most exposed to significantdownside."

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

There are signs investors are wary of some sectors. The techhardware, semiconductor and auto sectors are being targeted byshort sellers, with 7 percent, 3.8 percent and 3 percentrespectively of shares on loan, Markit data shows.

"Earnings ... will be difficult and therefore the market islikely to have a turbulent period and some correction," saidStan Pearson, head of European equities at Standard LifeInvestments.

View Comments (0)