The euro's blistering rise to a two-year high could start to threaten the bright outlook for European firms' profits, big brokers and investors warned, putting a dampener on enthusiasm around the region's equity markets which have drawn strong inflows this year.
More than half the revenue of top European firms is generated outside the euro zone, according to Thomson Reuters data, meaning a strengthening euro has an adverse impact on those revenues once they are brought home. As European earnings season kicks off in earnest over the coming week, the extent to which the euro's rise is hurting companies earning revenue outside the euro zone will be a key area of focus for investors.
Every 10 percent rise in the euro trade-weighted index takes 5 percent off the STOXX 600 earnings per share (EPS), Deutsche Bank strategists found. For Nandini Ramakrishnan, global market strategist at J.P Morgan Asset Management Europe remains the most favoured equity market globally given a good economic backdrop and recovery in earnings growth, but the strengthening currency is a concern.
"The main challenge for European equities is the strength of the euro," said Ramakrishnan. Earnings growth in Europe is expected to come in at around 14 percent this year, according to Thomson Reuters data, a striking turnaround after five years of sluggish to zero profit improvements.
The upbeat outlook for European earnings has seen global investors pump money back into regional stocks pushing up valuations to above long-term averages. Some $19 billion has poured into European equities over the past three months, EPFR data shows. "We do expect the currency to strengthen given the ECB tapering, but that should not derail earnings growth," Ramakrishnan added.
The euro has run up this year as a brightening macroeconomic backdrop dovetails with easing political concerns after the French election and an ECB getting ready to ease stimulus as inflation picks up. For strategists at Deutsche Bank the relatively weak start to European earnings season is partly down to the euro's strength. "With the euro trade-weighted index up 5 percent between the middle of April and the end of June, FX strength is set to weigh on euro earners' results, which will likely contribute to subdued beat ratios for the remainder of the season," the strategists said in a note.
Roughly 18 percent of the MSCI Europe index constituents have reported results so far. Morgan Stanley strategists also voiced their concerns, pointing out that the earnings revisions ratio - a metric which tracks the number of upgrades to downgrades and measures analyst sentiment - has hit an 11-month low with financials the only sector not seeing downgrades.
Companies that are more export-focused are the most exposed to a strengthening euro which makes their products more expensive abroad. Industrial stocks are on track for their biggest one-month loss since October 2016, having fallen over the past two months, while export-focused autos have held up better, managing a 1.2 percent gain so far in July against a loss of 1.3 percent for the STOXX 600. Autos were the worst-performing sector on Friday, down 2.4 percent. Industrials have drawn particular attention, with Deutsche Bank highlighting their weak results so far as a reason for the lacklustre start to the earnings season.