Investors should be on guard for more signs of how banks are coping with the credit squeeze and how this is affecting the real economy, strategists said in the run-up to a week with scant corporate news on the agenda.
Tesco, the world's third largest retailer, is among a few European companies of note scheduled to report results. The economic data calendar, on the other hand, contains some vital indicators to watch and monetary policy will also be a key theme as the European Central Bank and the Bank of England meet - both on Thursday - for interest rate decisions.
The outlook for economic growth, a driver of corporate earnings prospects, will impact stock markets. "If general economic conditions deteriorate, company profits will take a big hit," Societe Generale said in a cross-asset research note.
"There are increasing risks that the credit market crisis spills over into the real economy," it said. Citing similar concerns, LandesBank Berlin (LBB) said it remained sceptical about the near-term stock markets outlook. "A renewed test of mid-August lows is definitely possible," LBB said in a weekly capital markets outlook note.
The FTSEurofirst 300 index of top European shares is up some 8.5 percent from the low set in mid-August after a month-long plunge sparked by concerns about the fall-out of the credit squeeze that began in the US subprime mortgage market.
Interest rate cuts by the US Federal Reserve and liquidity infusions by the Fed and other central banks eased some fears and helped a recovery in equity markets underpinned also by low price-to-earnings (P/E) valuations.
According to Goldman Sachs, European shares are trading at 12.5 times consensus 12-month forward earnings compared with an average P/E multiple of 14.9 since 1988. "In aggregate, the market is not obviously expensive," Goldman Sachs said in a note.
But Steffen Neumann, equity strategist at German bank LBBW, said one of the central uncertainty factors was how realistic current earnings forecasts are. More clarity would come only with the release of companies' third-quarter results, he said.
European non-financial firms would continue to enjoy robust profit growth, although some may suffer from the euro's recent appreciation, said Heinz-Gerd Sonnenschein, equity strategist at Germany's Postbank.
It was a different story in the financial industry where, Sonnenschein said, "all the cards are not yet on the table." "The list of financial companies suffering liquidity problems is growing ever longer," he said, adding: "Financial stocks remain under pressure."
Societe Generale argued that banks' weaker earnings would prompt them to reduce lending, which in turn would hold back corporate investment necessary for future profit growth. "In the banking sector, profits will obviously fall as trading profits are hit and new issuance business weakens," Societe Generale said. "The bigger the trading losses, the more potential there will be for banks to rein in lending."
Before the onset of the credit crisis, debt-financed mergers and acquisitions (M&A) were among factors propelling stock markets higher. Lately, however, M&A activity has slowed. DZ Bank said the volume of M&A transactions in Europe so far this month was $86 billion compared to $87 billion in August and sharply down from an all-time high of $444 billion set in April. "The weak M&A volume in September is new feed for bears betting on weaker investment banking results," DZ Bank said.
Tesco, which reports half-year results on Tuesday, is expected to post a 3 percent rise in UK like-for-like sales excluding fuel. Underlying pre-tax profit is seen rising to 1.3 billion pounds ($2.64 billion) from 1.15 billion a year earlier. Other corporate updates next week include September traffic data from several airlines, notably British Airways and SAS, as well as quarterly results from Danish up-market consumer electronics maker Bang & Olufsen.
The highlights of next week's macro economic diary are US manufacturing ISM on Monday and US non-farm payrolls on Friday. A raft of euro zone indicators are also in store. Both the ECB and the BoE are widely expected by analysts to leave interest rates unchanged, but market watchers will scrutinise the accompanying comments for clues about the direction of any potential future monetary policy shifts.
"We expect the ECB to maintain its wait-and-see stance," Commerzbank said. "It will keep its options open for a further interest rate hike at a later date," it said, noting that the ECB wanted "hard facts" regarding the effects of the financial market crisis on the real economy before deciding its next move.
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