Graham Secker: Do European Earnings Have Further to Fall?

While European earnings have been remarkably resilient this year, and consensus estimates for earnings and corporate margins remain high, there may be reason to believe there’s further yet to fall.

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Welcome to Thoughts on the Market. I'm Graham Secker, Head of Morgan Stanley's European Equity Strategy Team. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the outlook for European earnings for the upcoming third quarter reporting season and beyond. It's Thursday, October the 20th, at 2 p.m. in London.

Having been cautious on European equities for much of this year, we have recently started to flag the potential for more two-way price action in the near-term, reflecting a backdrop of low investor positioning, coupled with the potential for an inflection in U.S. inflation and interest rates over the next few months. To be clear, we haven't seen either of these two events occur yet, however we are conscious that each week that passes ultimately takes us closer to just such an outcome. Given that high inflation and rising interest rates have been the key drivers pushing equity valuations lower this year, any sign that these two metrics are peaking out would suggest that we are approaching a potential floor for equity PE ratios. However, while this is good news to a degree, history suggests that we need to be closer to a bottom in the economic and earnings cycle before equity markets put in their final price low.

So far this year, European earnings have stood out for their remarkable resilience, with the region enjoying double digit upgrades on the back of currency weakness and a doubling of profitability for the energy sector. Looking into the third quarter reporting season, we expect this resilience to persist for a bit longer yet. Currency effects are arguably even more supportive this quarter than last, and the global and domestic economies have yet to show a more material slowdown that would be associated with recessionary conditions. Our own third quarter preview survey also points to a solid quarter ahead, with Morgan Stanley analysts expecting 50% of sectors to beat consensus expectations this quarter versus just 13% that could miss.

Longer term, however, this same survey paints a more gloomy picture on the profit outlook, with our analysts saying downside risks to 2023 consensus forecasts across 70% of European sectors and upside risks in just 3; banks, insurance and utilities. In the history of this survey, we have never seen expectations this low before, nor such a divergence between the short term and longer term outlooks.

From our own strategy perspective, we remain cautious on European earnings and note that most, if not all of our models are predicting a meaningful drop in profits next year. Specifically, consensus earnings look very optimistic in the context of Morgan Stanley GDP forecasts, current commodity prices, dividend futures and the latest readings from the economic indicators we look at, such as the purchasing managers indices.

In addition to a likely top line slowdown associated with an economic recession, we see significant risks around corporate margins, too. Over the last 12 to 18 months, inflation has positively contributed to company profitability, as strong pricing power has allowed rising input costs to be passed on to customers. However, as demand weakens, this pricing power should wane, leaving companies squeezed between rising input costs and slowing output prices. In this vein, our own margin lead indicator suggests that next year could see the largest fall in European margins since the global financial crisis. However, consensus estimates assume that 16 out of 20 European sectors will actually see their margins expand next year.

Our concern around overly optimistic earnings and margin assumptions next year is shared by many investors we speak to. However, this doesn't necessarily mean that all of the bad news is already in the price. Analyzing prior profit cycles suggests that equity markets tend to bottom 1 to 2 months before earnings revisions trough, and that it takes about 7 to 8 months for provisions to reach their final low. If history repeats itself in this cycle, this would point to a final equity low sometime in the first quarter of 2023, even if price to earnings ratios bottom later this year.

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