Market Analysis: European Earnings Face a Low Bar Amid Growing Investor Impatience

The European earnings season is underway, and investors are cautiously optimistic about the outcome. Despite the challenges posed by China's faltering economy and global inflation, there is a glimmer of hope that European stocks may manage to stay in the positive territory. The expectations are set so low that any positive surprises are likely to be warmly welcomed by investors.

The Lackluster Earnings Season

Unfortunately, this earnings season has seen fewer positive surprises than usual. Of the companies listed in the European STOXX 600 index (.STOXX), less than half have managed to beat expectations, which is below the typical quarter's performance. Shareholders have become increasingly unforgiving of any earnings misses, indicating that the market's patience for mediocre results is running thin.

The European index experienced a 9% increase in value earlier this year, primarily driven by optimism surrounding China's post-COVID reopening and relief that Europe was likely to avoid recession. However, with Chinese growth losing momentum and facing persistent global price pressures and rising borrowing costs, concerns have arisen regarding the performance of European companies exposed to the world's second-largest economy.

Low Bar for Positive Outcomes

Due to the challenges faced by European companies, the expectations for beating earnings estimates are relatively low. Axelle Pinon, a member of the investment committee at asset manager Carmignac, notes that the equity valuation expansion in Europe has been more limited compared to the U.S. As a result, fewer upward revisions in earnings projections are needed to support the ongoing market rally.

According to Refinitiv Datastream, the STOXX 600 is currently trading at a PE ratio of 15.66, while the S&P 500 (.SPX) boasts a ratio of 24.9, marking the largest discount in at least 24 years. This discrepancy in valuation indicates that the market is valuing European stocks at a more conservative level.

Analysts' Forecast and Bright Spots

Analysts have been consistently lowering earnings forecasts for MSCI Europe companies since June 23, reflecting the longest stretch of downward revisions since the outbreak of the Ukraine war last February. For the second quarter, STOXX 600 company earnings are projected to drop by 8.1% year-on-year, showing a slight improvement from the initial forecast of a 9.2% drop. Nevertheless, it remains the worst quarter for corporate results since 2020, according to Refinitiv I/B/E/S data.

Despite the gloomy outlook, there have been some bright spots during this quarter. French carmaker Renault (RENA.PA) reported robust global car sales, while Unilever (ULVR.L), the maker of Dove soap and Ben & Jerry's ice cream, exceeded forecasts by successfully implementing price increases.

Investors' Harsh Punishment

The European earnings season has seen an unusual pattern in investors' behavior. Companies that missed earnings expectations faced harsher punishment than at any point in the last five years, according to Bank of America. The beat ratio, which measures the number of companies exceeding expectations, is at its weakest since late 2019. This underperformance resulted in a median one-day loss of 2%, the most significant negative reaction since the final quarter of 2017.

For instance, Electrolux (ELUXb.ST), Europe's largest home appliances maker, suffered a significant loss in market value when it reported a second-quarter loss, with one-fifth of its market value wiped out.

The Uncertain Road Ahead

Even for companies that manage to beat expectations, the road ahead remains uncertain. LVMH (LVMH.PA), Europe's most valuable company, experienced a 5% market value loss after reporting sales that met expectations but provided a less upbeat forecast.

The outlook beyond the second quarter is rather gloomy. While customers have managed to absorb higher prices so far, it is unclear how much potential consumer squeeze could impact profit margins. The forward 12-month net profit margin for the STOXX 600 is currently 9.9%, down from the all-time high of 10.1% in November 2022.

Ben Jones, the director of macro research at Invesco, predicts that earnings beats will be harder to come by in the upcoming quarters, with inflation likely to erode profit margins further. As the consumer squeeze deepens throughout 2023, the situation is likely to worsen.

In Summary, the European earnings season is unfolding with cautious optimism as investors grapple with various challenges. Despite low expectations, some companies have managed to exceed forecasts, providing a glimmer of hope for the market. However, the road ahead remains uncertain, with concerns about global inflation, economic slowdown, and potential price wars casting a shadow on the European economy. Investors must exercise caution and stay vigilant amidst these volatile times.