LONDON The rising cost of raw materials is likely to be risk for European firms, Goldman Sachs said, adding that the impact of inflation and companies' pricing power were key themes emerging from the ongoing results season.
Rising commodity prices have fueled increased inflation expectations in Europe, and sparked the so-called "reflation" trade since last summer as investors rushed into shares of banks, industrials and resources firms.
However, higher prices for raw materials compounded by weaker currencies like sterling mean that for those companies unable to pass on costs to customers, profit margins are likely to come under pressure.
Overall, fourth quarter earnings in Europe are expected to rise 12.3 percent, according to Thomson Reuters I/B/E/S data while sales are seen rising only 1.7 percent, underscoring the investor focus on profit margins.
European industrials and consumer-facing companies could be among those most affected, Goldman Sachs said, and those with already low margins were most vulnerable.
"On recent earnings calls, several companies have highlighted that raw materials are expected to move from a being tailwind in 2016 to a headwind in 2017," said analysts at Goldman Sachs in a note to clients.
The U.S. investment bank pointed to recent comments from Electrolux (ELUXb.ST), Volvo (VOLVb.ST) and Unilever (ULVR.L), among others, highlighting rising costs of everything from chemicals, plastics to palm oil.
In this environment, Goldman Sachs recommends investors seek out companies that have a history of pricing power.
Assa Abloy (ASSAb.ST), Michelin (MICP.PA) and Legrand (LEGD.PA) in the industrial goods sector have shown stable historical margins, suggesting they are among those companies able to withstand cost pressures, Goldman said.
There was limited evidence that wage pressures were building up at European firms, though Goldman warned that this could be risk for those companies exposed to the U.S. and the UK.
Bakery firm Aryzta (ARYN.S) plunged last month after a profit warning blamed partly on rising costs.
Wage increases in the U.S. could hit firms such as Wolseley (WOS.L), Ahold Delhaize (AD.AS), Bunzl (BNZL.L) and Fiat Chrysler (FCHA.MI), whose U.S. sales exposure is between 58-66 percent according to Goldman figures.
(Reporting by Kit Rees, Editing by Vikram Subhedar)