Why a stronger euro is no barrier to European profit growth
The improved pricing environment in Europe is one of several factors that can offset the headwind from a stronger currency.
The pick-up in the euro compared to the US dollar has been a source of concern for some market observers, amid worries that it could put a halt to earnings momentum in Europe.
We acknowledge that the stronger currency does act as a headwind for exporters, but we see numerous other factors that can support ongoing earnings growth in the region.
Euro strengthening for over a year
As chart 1 below shows, the euro has been strengthening versus the US dollar for over a year, and European earnings have delivered strong growth despite this. We also note that the opposite environment, i.e. a strong dollar and weak euro, prevailed during 2015 and 2016 and this failed to lift Europe’s corporate profits.
Chart 1: The euro has strengthened recently versus the US dollar
This would indicate to us that economic growth rates are a more important factor than exchange rates in boosting corporate earnings.
The recent strength in the euro is a sign of a more robust economy and the underlying fundamentals of the European economy are in good health.
Although the appreciating euro is somewhat tempering the rate of earnings per share (EPS) increase within the eurozone, EPS estimates for 2017, 2018 and 2019 have all been revised higher in continental Europe, as chart 2 shows below.
Chart 2: Earnings per share (EPS) forecasts revised higher
Improved pricing environment for corporates
What is the driving force behind these upward revisions to earnings? In our view, it is primarily the return of inflationary pressure in Europe. As chart 3 shows, the eurozone producer price index is now out of negative territory.
Chart 3: Euro area producer price index is no longer negative
This reflation means greater pricing power for corporates, i.e. they have the ability to raise prices without denting demand. We expect the positive impact of this on corporate profit margins to more than offset the negative impact of a stronger euro.
This inflationary pressure is the main reason why we remain optimistic on eurozone EPS growth. Inflation is likely to continue to build because capacity is in short supply in Europe and unemployment is falling. Tight capacity means companies either need to expand in order to produce greater volumes, or they can raise their prices. Tighter labour markets mean workers can demand higher wages.
However, we do not expect inflation to get out of hand, and note that it currently remains below the European Central Bank’s target.
We have already seen 23% year-on-year growth in eurozone earnings, highlighted in chart 4 below. It is worth noting that this acceleration has been achieved despite a strengthening euro.
Chart 4: Earnings momentum is much improved
If the US dollar were to strengthen again, perhaps as a result of the Federal Reserve hiking interest rates faster than the market currently expects, then we would expect this to enhance the already-solid earnings momentum in Europe.
Other factors underpin earnings momentum
There are additional reasons to expect euro area earnings growth to continue its recent improvement. One is the buoyant manufacturing sector as demand remains robust, while stronger growth within the eurozone itself can boost the earnings of domestically-exposed companies.
Another factor is that many European companies are initiating share buybacks, following a trend that has long been underway in the US. This should be accretive to earnings, though perhaps not to the same extent as it has been for US stocks.
Importantly, Europe is home to strong brands. Premium cars and luxury goods from Germany, Italy and France are not easily replaced with cheaper alternatives from elsewhere. The current global growth environment is another positive as strong international markets are more likely to absorb higher ticket prices than weak ones.
The introduction of tariffs on steel and aluminium by the US adds an element of uncertainty to the picture, though it remains unclear how this will play out. Nonetheless, we see global growth continuing. In our view this, combined with the improved pricing environment, robust domestic demand, and Europe’s world-class brands, can support ongoing positive earnings momentum in the eurozone.