LONDON/FRANKFURT Inflation concerns in Europe are showing no signs of letting up, forcing equity investors to reduce exposure to vulnerable sectors, with German shares particularly prone to further inflation risks.
Inflation in Britain rose to 4 percent in January, double the BoE's targets, while euro zone inflation hit a 15-month high at 2.4 percent and is likely to exceed the ECB's target of just below 2 percent for most of the year.
A rise in commodity prices following a $600 billion stimulus programme by the U.S. Federal Reserve has been partly responsible for surging global inflation, with copper prices up nearly 35 percent since the Fed first mooted the idea of second-round quantitative easing, or "QE2", in August 2010.
With inflation levels in the United States subdued for now, the Fed is unlikely to tighten policy anytime soon, leaving the country awash with "hot money" which would further spur demand for steel and oil from emerging economies.
This in turn could drive raw material costs higher and eat into margins.
Deutsche Bank research shows that a 20 percent increase in commodity prices in 2011 would knock 2-3 percent off expected earnings-per-share growth for the STOXX Europe 600 index as margins get squeezed.
"The Fed isn't going to curb the appetite for goods and services in the United States so that will feed global growth and add to the inflation pressures that apply already," said Mike Lenhoff, chief strategist at Brewin Dolphin.
Historically, equities are deemed to be in a sweet spot when inflation levels stay at levels of 3.5-4 percent as it strengthens profits through pricing power.
But rising inflation in Europe is prompting concerns about price-to-earnings valuations as increased costs will be harder to pass on.
Analysts said firms in the airline, retail and capital goods sector which are competitive on pricing will find it harder to pass on costs, with Deutsche Bank singling out Peugeot (PEUP.PA), ABB (ABBN.VX) and Air France-KLM (AIRF.PA).
Early casualties include H&M (HMb.ST), which warned on the impact of rising raw material and labour costs, while Swedish bearings maker SKF (SKFb.ST), seen as a bellwether for the manufacturing sector, also said it faced rising costs.
Commodity producers such as oil majors and mining firms, however, are likely to find it easier to pass on price increases while luxury goods are also set to benefit on the back of strong demand from consumers in China and India.
NOT SUPER JOLLY
"Consumers aren't feeling super jolly yet. I don't think you can pass on a lot of price increase to them," said Karen Olney, strategist at UBS.
"It will be tricky and volumes will probably suffer."
The STOXX Europe 600 retail sector .SXRP is flat for the year, compared with a 4.8 percent rise on the STOXX Europe 600 index, with a P/E ratio at 12.8, compared with 11.3 for its peers, Thomson Reuters data showed.
The STOXX Europe 600 basic resources index .SXPP has a one-year forward P/E of 9.1.
An additional risk to profitability comes from second-round effects, leading to profit hits in vulnerable countries such as Germany, where strong economic growth and modest inflation have led to chunky wage demands.
"Some observers see Germany as one of the industrialised countries where the surge in food and commodity prices might trigger second-round effects via higher wages," Deutsche Bank chief international economist Stefan Schneider said.
Europe's largest carmaker Volkswagen (VOWG_p.DE) earlier this month agreed to a 3.2 percent wage hike for around 100,000 workers, compared with the average 1.8 percent increase seen across Germany in 2010.
Further substantial wage battles are looming. Last week, unions rejected a 2-percent wage hike offer from Deutsche Telekom (DTEGn.DE), one of the country's largest employers.
"If investors start to see higher inflation numbers that are sustainable they will start to anticipate that wages are not going to stay where they are. That will cause panic," said Thierry Serero, a fund manager at Octopus Investments.
The impact is already being felt.
According to Thomson Reuters StarMine, earnings per share for German large and midcaps are expected to grow 15.5 percent over the next 12 months, compared with 17 percent for France and 21 percent for Britain.
With its large weighting in capital goods and the prospect of higher wages in Germany, investors may be looking to book some profits on the DAX .GDAXI, particularly as valuations look stretched compared with its major European peers.
(Additional reporting by Harro ten Wolde; Graphic by Scott Barber; Editing by David Cowell)