- Macro Strategist
Switzerland, Institutional
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The earnings and margins of European companies have been unexpectedly resilient over the last couple of years, with the Q2 earnings season once again surprising to the upside. However, beneath the surface, I believe the outlook for European earnings is more challenging than the headline numbers suggest. What could this mean for investors and how could this influence European Central Bank (ECB) policy decisions?
Is earnings resilience obscuring downside risk?
Despite a deteriorating economic outlook and increasingly cautious forward guidance, Q2 saw an unusually large number of European companies exceed earnings expectations.
However, while the path of the global cycle is crucial, I believe European earnings face downside risks. I expect flat European earnings growth in 2024 and only mid-single digit earnings per share (EPS) growth in 2025 (2025 consensus EPS growth is around 10%1). This has potential implications for ECB policy and sector allocation. Here are five developments I am monitoring.
1) The signs may be subtle, but a rotation is arriving
On the face of it, H1 earnings momentum remained strong. However, a closer look reveals a clear rotation away from the cyclical parts of the market that have driven European earnings growth over the last few years. According to JP Morgan, more economically sensitive sectors — such as consumer discretionaries and materials — were a drag on European earnings growth in Q2.2 This rotation is also evident in the US, where earnings growth of cyclicals has lagged that of defensives for the first time since 1Q22.
2) A slowing global cycle could impact European earnings more than the European cycle
Uncertainty around the global cycle is another reason for caution. European equities are unusually international, with less than 40% of revenues coming from Europe.3 This makes European earnings more sensitive to the global cycle than to the European cycle. The current level of global purchasing manager indices points to downward pressure on earnings growth over the next year, and this could intensify if global growth momentum slows.
Corporate guidance is starting to reflect the weaker global growth backdrop. Forty European companies have cut guidance during the Q2 earnings season, with the majority citing weak demand.4 This is the highest number in more than a year and double the number that cut guidance in Q1.
I expect this to continue, especially if recent announcements by Chinese policymakers fail to stabilise the Chinese economy.
3) Higher rates are about to bite, even as central banks cut
In anticipation of the tightening cycle, companies have extended the maturity of their debt, meaning they have largely been shielded from higher borrowing costs. However, a growing amount of debt has to be refinanced in the coming years and even if rates come down further, many companies will continue to roll into higher rates. Accordingly, we are seeing a rise in interest expenses as a percentage of earnings, and I expect this to continue even as rates come down.
4) High margins are expected to come down
European margins are significantly above their post-GFC norm. I expect to see at least a partial normalisation in margins, especially if the global cycle slows over the coming months, with sectors such as car manufacturers being particularly vulnerable.
5) Producer price deflation will continue to weigh on European earnings
For a couple of years following the pandemic, domestic producers had unusual amounts of pricing power and received increasingly higher prices for their output, as reflected in high producer price inflation (PPI). However, more recently, corporates in the euro area have started to face falling output prices (Figure 1). This has historically been a leading indicator of pressure on margins and negative earnings growth.
Figure 1
What does this mean for the ECB?
Slowing earnings growth and falling margins should be supportive of further monetary easing by the ECB, which has been closely monitoring margins and earnings.
Supply chain challenges, the energy crisis, and pent-up demand post-COVID allowed many companies to increase prices beyond what was justified by higher costs, boosting profits and margins. This partially explains why European earnings growth has outpaced a range of macroeconomic indicators, particularly since COVID restrictions ended, but it has also significantly contributed to inflation. The IMF estimated that, at one point, rising corporate profits accounted for almost half of the increase in European inflation.5
The ECB has therefore made it a priority to lower profit margins and limit earnings growth. Recent trends in earnings and margins suggest that the ECB's efforts are bearing fruit, providing justification for further easing of policy measures.
Investor implications
In my view, this is unlikely to be a significant headwind for European equities in aggregate (attractive aggregate valuations suggest some of this earnings pressure is already in the price) but will be important for relative sector and stock performance. I think fundamental research is crucial as stocks and sectors with relative earnings strength are likely to be the biggest winners in this environment. And looking at the broader picture, weaker earnings could enable the ECB to cut more, and doing so, could boost the fortunes of Germany and other struggling core euro-area economies.
1IBES, October 2024. | 2Q2 Earnings Season Tracker – Key Takeaways, JP Morgan, August 2024. | 3Global Exposure Guide 2024 – Europe, Morgan Stanley, July 2024. | 4BofA, Bloomberg, Google News, FactSet, as of July 2024. | 5Hansen, Niels-Jakob, Frederik Toscani, and Jing Zhou. 2023. “Europe’s Inflation Outlook Depends on How Corporate Profits Absorb Wage Gains.” IMF. 26 June 2023. https://www.imf.org/en/Blogs/Articles/2023/06/26/europes-inflation-outlook-depends-on-how-corporate-profits-absorb-wage-gains.
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