Although Europe’s economies appear to be on the path to recovery, this has not yet started to show up in companies’ bottom lines.
“The overall earnings trend is troughing about now,” says Graham Secker, Morgan Stanley’s head of pan-European equity strategy. “The macro data has been turning up for six to 12 months, but it takes a while for this to feed through into earnings.”
The fourth-quarter earnings season in Europe will peak on Monday. With 235 companies from the Stoxx 600 index of European companies having reported results so far, and 133 left to report, negative surprises on revenue growth have so far outweighed positive surprises. In seven out of 10 sectors, according to Bloomberg, sales have continued to fall.
“Q3 saw the weakest reporting season for revenues [for European companies] since 2009 due to euro strength, emerging market weakness and a sluggish global recovery,” says Karen Olney, head of European thematic strategy at UBS.
“So far in the fourth quarter [positive] earnings surprises have fallen to their lowest since we fell back into recession in the second half of 2011.”
“The macro-environment in 2013 was one of soft growth, minimal in the developed world and below recent levels in the emerging markets,” said Paul Bulcke, Nestlé chief executive.
Despite disappointing revenue growth at many of the European companies to have reported so far, profits have ticked up, reflecting efforts by many corporates to cut costs.
“If you look at the aggregate profits data, that has been pretty weak in Europe for a while,” says Dario Perkins at Lombard Street Research. “But there has been [profit] margin recovery, due predominantly to cost cutting – wage growth has come down sharply.”
But despite efforts to keep costs down, profit margins in many sectors remain depressed.
“In 14 European sectors, accounting for 60 per cent of Europe’s market earnings, operating margins are below their 10-year average,” says Ms Olney of UBS.
Morgan Stanley’s Mr Secker believes profitability is about to improve.
“Margins are stabilising,” he says. “This will be the first year for three years when margins don’t contract.”
Performance at many large European companies in the fourth quarter was affected by sector-specific factors.
The oil sector has had a particularly weak results season, as the majors struggle with rising costs, sliding production and a stagnant oil price. Royal Dutch Shell and BG Group both issued profit warnings and most of the others, including BP, reported big drops in profit.
At Europe’s banks, earnings were hit in part by one-off charges relating to restructuring, provisions and higher costs. RBS, for example, took a £1.9bn litigation charge for settlements relating to US mortgage-backed securities.
But some themes have been consistent across sectors.
Philips reported better than expected fourth-quarter earnings last month but its chief executive warned that economic jitters and social unrest in emerging markets would make 2014 a tough year.
“Structurally, Philips is well positioned for growth markets,” said Frans van Houten. “[But] social unrest like in Ukraine and Turkey as well as currency movements like in Indonesia in the near term are not helping us.”
Weak demand in the emerging markets was highlighted at several results announcements.
“The biggest split has been between companies exposed to emerging markets, which have surprised negatively, and those more exposed to Europe, which have done better,” says Sharon Bell, European equity strategist at Goldman Sachs.
Unilever was forced to issue a warning last September because of a slowdown in emerging markets. At its results announcement last month, the consumer group said currency weakness there had contributed to a fall in sales.
Siemens, the German industrial conglomerate, also suffered from the strong euro, with revenues declining 3 per cent despite a large jump in new orders. DSM, Electrolux, Lafarge, Renault and Pernod Ricard also reported a negative impact from currency movements.
“The most obvious [concern] is volatility in exchange rates,” said Carlos Ghosn, Renault’s chief executive. “Last year the weakening of the emerging market currencies cost us €600m, [so the] collapse of the real, the rouble and the rupee has an impact on us.”
Many analysts believe the impact on companies could be sustained.
“The issue for Europe and the UK is about domestic currency strength,” says Mr Secker of Morgan Stanley. “European companies will face a fairly persistent FX headwind.”
“But the bigger risk would be if we started to see real weakness in terms of emerging market macro data. So far, this has not shown up.”
Although policy makers have warned of the dangers of deflation in the eurozone, this has not been a theme of the region’s earnings season so far.
Nestlé was one company that bucked the trend. It cited “prevailing deflationary pressure” as one reason why European sales had risen just 0.8 per cent in the fourth quarter.
And analysts agree that, if signs of deflation became more pervasive, it would be a bigger concern for investors.
“Disinflation so far has been benign and has boosted real incomes,” says Lombard Street Research’s Mr Perkins. “But if you got deflation, investment and expenditure would be deferred.”
Despite the generally gloomy tone to earnings season so far, there is a widespread feeling that the fourth quarter may mark the end of Europe’s earnings doldrums.
Ms Olney at UBS says the gap between surveys of sentiment or manufacturing companies’ intentions and earnings is “verging on the bizarre”.
“The operating leverage expected in 2014 is akin to 2003/04 when profits exploded,” she says. “As we flush out the bad news, we open the door to an even better 2014.”
“Companies will start to feel more optimistic, they will start to invest and hire, and then there will be profit improvement. We are still in the very early stages of that,” says Mr Perkins.
Additional reporting by Chris Bryant in Frankfurt, James Fontanella-Khan in Brussels, James Shotter in Zurich and Michael Stothard in Paris