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What traders are watching during this earnings season in Europe

[LONDON] 2017 was the year that breathed life into European corporate profits. Now, investors and analysts are asking: Can the momentum continue?

The answer will set the tone for the direction of European equities in the months ahead. The fourth-quarter earnings season begins at the heels of stocks' best start to the year since 2013 and amid the broadest eurozone expansion in almost two decades. Strategists say the stronger economy and recovering commodity prices open the door to positive surprises, though caution that a rising euro could damp numbers for some exporters.

"There has been a feeling that earnings in Europe have been disconnected from the top-down, macro story for a while," Emmanuel Cau, an equity strategist at JPMorgan Chase & Co, said.

"People need to see that earnings are finally rebounding in Europe consistent with the pick-up in activity. Macro could again become the most important driver going forward."

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Lower expectations are helping as well: despite a booming German economy - the region's biggest - analysts are less optimistic about European profits than about global earnings, widening the scope for upside. Data compiled by JPMorgan show analysts expect fourth-quarter profit growth at Stoxx Europe 600 Index members of 10 per cent, versus about 9 per cent for peers in the S&P 500 Index.

Here are some of the key themes investors and strategists are eyeing ahead of the onset of the latest earnings season.

US Tax Reform: Fund managers will parse statements for any guidance on the impact of US tax changes on Europe's firms, according to MPPM EK's Guillermo Hernandez Sampere, and stand ready to shift money into the biggest beneficiaries.

"When it comes to US tax reform, we need it in black and white what kind of effects it will have on a company's balance sheet," the head of trading said from Eppstein, Germany. He expects positive readacross for the car sector, a view echoed by Citigroup Inc.

JPMorgan sees about 2 to 3 per cent upside to 2018 profit estimates for European companies from lower US taxes. Though the region's firms stand to benefit less than US peers, as only about 20 per cent of their revenue comes from the US and they have a lower effective tax rate, the positive impact is less priced in, according to Mr Cau.

A basket compiled by the bank of potential European beneficiaries includes Ferguson, Grifols, Bunzl, Experian, Roche Holding, Barclays, Centrica and Sanofi. Ferguson said on Monday it estimates a group effective tax rate of about 25 per cent for the current financial year, a reduction from previous guidance of 28 per cent.

Stronger euro: With the shared currency breaching US$1.20 again, its potential to drag on Europe's exporters is back in the spotlight. Though the stronger euro has likely already been factored into most analysts' models, it could cap the potential for positive sales surprises this quarter, JPMorgan says.

According to Bank of America Merrill Lynch, a euro at an average of US$1.25 through 2018 would imply a drag on profits equal to more than half the consensus forecast for this year's earnings growth.

"If the euro remains at these levels and above, investors will have to adjust their expectations," Mr Hernandez Sampere said.

"There must be a line where it starts to really hurt."

Valuations: As global equities trade near their priciest levels in more than a decade, some see scope for further, albeit modest, multiple expansion in Europe. While the S&P 500 trades at 18.4 times expected earnings in the next 12 months, the Stoxx 600's price-to-earnings ratio, at 15.3, remains below its 2015 peak.

According to Bank of America, the earnings upside is "still not in the price". "Average valuations in Europe are not expensive," strategists including Ronan Carr wrote in a note. "Historically, price-to-earnings multiples and EPS often rose together in mid-late stages of the cycle. There is little evidence of euphoria on European equities."

Economy Boost: Goldman Sachs Group disagrees, claiming that valuation multiples won't rise further as investors have paid for Europe's earnings recovery "up front."

Instead, stocks are now more dependent than ever on the global economy, strategists led by Peter Oppenheimer wrote in a note.

But can the economy boost offset the drag from a stronger euro for a region that gets about half its revenue from outside Europe? According to Goldman, while a 10 per cent rise in the euro trims only 1.5 percentage points from Stoxx 600 earnings per share, a one percentage point increase in sales-weighted gross domestic product adds 11 percentage points to the measure.

Going forward, Goldman sees cyclical stocks sensitive to the economy outperforming and value sectors recovering. Financial and energy companies have the largest weighting in an MSCI gauge of Europe's value stocks.


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