MILAN (Reuters) - The European results season shifts into gear next week with equity valuations at their highest in more than a year and investors betting that the engine of earnings upgrades has plenty more fuel in the tank.
Wall Street stocks have been driven to records by President Donald Trump’s tax reforms and a weakened dollar. In Europe, investors see “better quality” earnings growth with firm roots in increased demand fuelled by economic growth across the region.
European stocks appear cheaper than U.S. stocks by certain measures. But they are expensive against their own historical average, implying solid profit growth momentum as the European Central Bank prepares to rein in economic stimulus. So any companies whose earnings disappoint could be harshly punished.
Fund managers willing to brave political uncertainty and a strengthening euro to bet on European stocks say the region is earlier in the economic cycle than the United States and its companies have greater scope to cut costs.
Europe’s main benchmark equity index is up 10 percent over the last 12 months, well short of a 24 percent leap for the U.S. S&P 500 .SP500.
“In Europe we are not late-cycle yet and companies have room to improve margins,” wrote Patrick Moone, head of macro and strategy at Dutch asset manager NN Investment Partners. “Earnings growth in the euro zone is of better quality... than in the U.S.”
Just a few months ago, Europe’s economy was expected to grow by around 1.7 percent in 2018. Now it is seen firmly above 2 percent.
Euro zone company earnings are expected to grow by about 10 percent for the second straight year in 2018, while EPS growth in the U.S. is seen at almost 15 percent this year after a 11 percent rise in 2017, Thomson Reuters data showed.
(Graphic for Euro zone earnings recovery runs into second year, click reut.rs/2DgUTEd)
European shares appear cheaper: euro zone .STOXXE stocks trade at 16 times earnings compared to 21 for the S&P 500 .SPX: the widest gap since TR data started in 1999.
(Graphic for Euro zone has never been this cheap vs Wall Street, click reut.rs/2DIvbJz)
However, a strengthening euro and concerns that China will stop the global economy accelerating this year mean not everyone sees a big expansion in European earnings this year.
Deutsche Bank is far more cautious than consensus, seeing only 2 percent EPS growth. Deutsche is even thinking of increasing its relative underweight position on European vs U.S. equities.
Perhaps the industries with most to prove this results season are those whose equity valuations have risen most in the past few weeks as a tide of money flowed out of bonds into assets likely to benefit most from the cyclical upswing.
(Graphic for Cyclicals leave defensive behind as 2018 starts, click reut.rs/2Dk5tu5)
Investors have piled into industrial companies, tech stocks and banks, while the appeal of defensive plays such as utilities or consumer staples has faded.
“There’s little room left for multiple expansion but the good news is that there should be synchronised growth across the world for the second year running,” said Gilles Guibout, head of European equities at AXA Investment Managers in Paris.
“Stocks are no longer cheap and what markets can hope for now is earnings growth.”
Guibout still likes banks, seeing them as cheap and carrying big cost-cutting potential. He said sector consolidation was “just at the beginning and it could be the only space where multiple expansion could be justified”.
He was not dramatically changing his sectoral allocation but was keeping an eye on companies with high levels of debt. He is also upbeat about stocks tied to technology like 3D design, payment systems and software that makes businesses more competitive.
Many investors say they are staying underweight on retailers with big store networks threatened by the shift online. In Britain, their problems are compounded by slowing consumer spending.
The powerful impact of bad news on companies was illustrated on Friday when British floor coverings retailer Carpetright (CPRC.L) and funeral services group Dignity (DTY.L) both lost almost half of their value after profit warnings.
Investors will be watching for any fresh evidence that European telecom companies are capitalising on big infrastructure investment by selling more data. Telecoms .SXKP are the only sector to have fallen significantly in the past year, while industrials .SX8P are up the most.
Other income sectors whose appeal may be dimming as bond yields rise are utilities -- hit by growing pricing pressure -- and consumer staples, which face questions about their ability to defend high profit margins.
Liberum says consumer staples shares may suffer in 2018 if faster growth does not materialise, or if central banks accelerate rate hikes and monetary policy normalization.
“We’ve been concerned about the fundamentals for consumer staples for a couple of years but seen it as a slow burning fuse,” Scott Meech, co-Head of European Equities at asset manager Union Bancaire Privee, said.
He said he does not own any of the big consumer staple names Unilever, AB InBev (ABI.BR), Reckitt (RB.L) and Nestle (NESN.S), which he sees as vulnerable to falling barriers to entry for new rivals and the high prices of some of their branded goods.
Additional reporting by Julien Ponthus and Helen Reid; editing by Tom Pfeiffer and Keith Weir