LONDON Euro zone equities are starting to feel the pinch of a strong euro, which threatens already low earnings, and carmakers, technology and luxury goods firms are likely to be the hardest hit.
The euro has risen 12 percent versus the dollar since European Central Bank chief Mario Draghi pledged in July to do whatever it takes to save the currency. A stronger euro reduces European firms' foreign earnings in domestic currency terms and makes it harder for them to compete with overseas rivals.
Although some domestic sectors could benefit from the cheaper imports, they are outnumbered by those who lose out.
Analysts at Morgan Stanley and Credit Suisse estimate that a 10 percent appreciation in the euro against a weighted basket of its biggest trade partners would cut euro zone economic output by 0.5 to 0.7 percent in the first year and dent aggregate corporate earnings by 3 to 4 percent.
"The euro strengthened on confidence and that is obviously helping European equities. But it gets to a point - and I think we are at that point - when it starts to weigh on European earnings," said Nick Xanders, who heads European equity strategy at brokerage BTIG.
Markets are already starting to react. The 30-day correlation between the euro/dollar exchange rate and the EuroSTOXX 50 .STOXX50E of euro zone blue chips has turned lower, retreating from six-year highs of 0.93 in a shift away from the trend seen since mid-2012, when the two markets rallied in tandem on improving sentiment on the region.
With the ECB effectively tightening its monetary policy as banks repay cheap loans taken from the central bank in 2011 and 2012 while its peers ease policy to stimulate their economies, the euro is expected to stay strong for a while longer.
The latest Reuters poll shows the euro holding around current levels for the next three months before easing to $1.28 by year-end. Forecasts range as high as $1.43.
"If this strength persists ... you should see the effects of it come through in first-quarter earnings, and certainly in analyst estimates and downgrades to estimates. Guidance could become a lot more cautious," said Ashish Misra, Head of Investments at Lloyds TSB Private Banking, highlighting autos .SXAE and pharmaceuticals .SXDE among the sectors at risk.
Although corporate hedging against exchange rate risk and the delay in reporting mean it will takes time for euro strength to be reflected in results, German carmaker Daimler (DAIGn.DE) and French luxury goods group LVMH (LVMH.PA) are among those who have already warned earnings may be impacted.
There are also signs that analysts are turning more cautious on the sectors that are likely to suffer, with technology, energy and healthcare suffering some of the steepest downgrades in earnings forecasts in the past 30 days, according to Thomson Reuters StarMine data.
Currency concerns are also filtering through into investors' strategies, prompting Bank of America Merrill Lynch to pick U.S. industrials and Japanese car makers over European peers and Morgan Stanley to downgrade European equities relative to Japan.
In a big boost to Japanese exports, the Bank of Japan has aggressively eased policy and the government has pledged massive economic stimulus, driving the yen sharply lower.
In Europe, Morgan Stanley highlights technology .SXTE and autos among likely relative losers, based on earnings exposure and historical performance at times of currency strength, with healthcare and capital goods also expected to be hit.
By contrast, winners could include utilities, retail, real estate, food and construction, as well as banks .SX7E, which have relatively little foreign exposure and are closely linked to swings in sentiment on the euro zone.
The recent popularity of some of the vulnerable sectors, which were bought for their foreign exposure while the domestic economy stumbled, could exacerbate the impact.
The stocks look expensive, and thus already prone to profit taking and not that attractive to new buyers. At the same time, the heavy levels of investment mean a lot of money could exit.
"The majority of portfolio managers out there are overweight consumer discretionary, as am I. In my case it's autos and for others it's luxury goods. So a strong euro won't be good for those companies if it strengthens further," said Kevin Lilley, European equities fund manager at Old Mutual AM, adding that he would reconsider his holdings if the euro rose to $1.40-1.45.
Bank of America Merrill Lynch picked technology and autos as potentially attractive sells, given the fact they have been so heavily bought, while suggesting that domestically-focused utilities, retail and telecoms, could be worth buying.
Technology looks the most expensive among euro zone sectors compared to the average price/earnings ratio of the past five years, while utilities and telecoms are among the cheapest, according to Thomson Reuters DataStream.
Europe as a whole looks expensive relative to its history, compared to the United States, emerging markets or Japan.
While that in itself is not a reason to sell, further outperformance by Europe would require solid earnings growth and a strong euro would be an obstacle, Morgan Stanley analysts said in a note.
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