LONDON (Reuters) - As the curtain comes down on the Q4 earnings season, it’s clear that Europe put on a show not seen for years. Investors hoping for a repeat performance this year, however, are likely to be disappointed.
The stars were aligned for strong earnings growth in 2017 in a way they won’t be in 2018: huge upside potential because the year before was so weak, analysts’ low expectations and the strongest GDP growth in a decade.
Investors outside the euro zone also saw their returns inflated by exchange rate moves, as the euro chalked up its best year against the dollar since 2003.
European corporate profits grew by 12.2 percent last year, the most since 2010 when earnings soared by a third following two years of crisis-hit negative growth. The best performing sectors were tech, industrials and financials.
That was more than earnings growth of 10.9 percent for S&P 500 companies, the first time in a decade that Europe outgunned the United States. But Wall Street is expected to turn the tables again this year.
Thanks to President Trump’s tax cuts, U.S. companies are in line for a one-off boost this year that analysts expect will result in earnings growth of 19.4 percent. The figure for Europe is seen slowing to 8.3 percent.
Investors are positioned accordingly. Forward price/earnings ratios, which measure a stock or index’s expected earnings growth potential, show investors putting an increasing premium on buying Wall Street over Europe.
Last year’s stellar profit performance in Europe was largely thanks to the continent’s strongest economic growth in a decade. Euro zone GDP rose 2.5 percent, but economists polled by Reuters expect that to slow to 2.3 percent this year.
In 2017 the euro zone outstripped U.S. growth of 2.3 percent but Trump’s tax cuts are expected to propel the rise in U.S. GDP to 2.7 percent this year, according to a Reuters poll.
Euro zone economic surprises consistently beat U.S. surprises last year, but not this year. The euro surprises index is falling off a cliff and is now negative, its lowest in two years.
Investors outside the euro zone enjoyed a double boost last year because the euro’s rise inflated the dollar value of their euro assets. The common currency climbed 14 percent against the greenback in 2017, its biggest annual rise for 14 years. For dollar-based investors who didn’t hedge their currency exposure, it meant an additional 14 percent of returns.
The euro is up 3 percent against the dollar so far this year but that pace of appreciation is expected to slow. A Reuters poll of analysts has the euro rising a further 3 percent from $1.23 currently to end the year at $1.27.
While Trump’s tax cuts may give the U.S. economy and corporate profits a shot in the arm this year, his protectionist tendencies could escalate global trade tensions. This could put the squeeze on corporate profits.
If the United States’ major trading partners respond with tit-for-tat tariff increases, companies will be forced to try to pass on the higher costs to consumers. Yet profit margins are already under pressure.
“Unless topline revenue growth is sufficiently strong to compensate for lower profit margins, achieving the strong earnings growth expected by analysts may prove challenging,” the Institute of International Finance said.
And as the following chart from the IIF shows, euro zone companies have far less room for manoeuvre than their U.S. or emerging market counterparts.
— The opinions expressed here are those of the author, a columnist for Reuters. —