Macro in Europe and results

Equities have rallied since the low point in June but several headwinds remain, including a slower economic outlook, tightened financial conditions, and the end of the reopening dynamics coupled with an uncertain gas supply in Europe.

Here are some thoughts regarding the European economic landscape and fundamentals behind companies having reported their half year financial results:

• The majority of European companies have reported their first half results. The levels of earnings beats remains very high. Indeed, the magnitudes of these beats have hit a new records. So far, 69% of companies in STOXX 600 index have reported revenues beating consensus while 17% missed. The revenue beat/miss ratio for this European index reached 4.0x at the end of July versus the 5-year average of 1.7x, according to BNP Paribas Exane Research’s Strategy on August 5, 2022.

• Amongst other things, European companies have benefited from the reopening of the economy and a weak Euro. Companies that generate a significant portion of their sales in U.S. dollar have experienced a positive translation effect on their top line. Looking at the performance by geographies, sales generated in North America outperformed while sales in China, Northern and Eastern Europe underperformed.

• On average, companies have been able to pass on higher input prices, allowing for strong sales growth. Prices for finished goods continue to rally as suggested by the Producer Price index which rose 35.8% in June versus the same period last year. Price increase in the second half of this year could be firmer.

• Supply chain challenges experienced over the last few years have encouraged companies to intensify stock building. The ongoing supply chain problems have pushed many companies to increase their raw materials inventory in order to avoid any disruption in the manufacturing of finished goods. This stock building trend has been particularly strong in industries like in the automotive or in tech hardware.

• Consumer sentiment deteriorates; with real disposable income falling, non-essential purchases like apparel may be impacted. This creates the risk of oversupply and possibly the need for general retailers to offer significant discounts to clear up inventory. Companies like Gap and Walmart have seen an increase in promotional activities. On the other hand, companies exposed to the service side of the economy continues to experience strong consumer demand. Travel and lodging remains a priority.

• We also observed a growing concern regarding labour shortages across many industries and countries. The lack of qualified staff within construction, transportation, hospitality and service sectors could eventually lead to cancellation and demand destruction.

• Regarding the energy crisis in Europe, the risk of Russian gas cut-off has the potential to cause significant damage to the EU economy, especially for Germany. The recent reduction in the Nord Stream 1 gas flow from 40% of normal to 20% should not trigger a formal rationing of gas but is expected to weigh on German activity. We further discussed Germany’s reduced gas supplies and its impact on our holdings in a recent commentary.

• Fiscal support over monetary policy tightening; with the suspension of EU fiscal rules until the end of 2023, member states will enjoy fiscal buffer to provide temporary relief to mitigate the impact of the energy crisis and the war in Ukraine. Funds from the Recovery and Resilience Facility should continue to support climate and digital projects.

Resurgence of political risk; the resignation of Italy’s Prime Minister Draghi adds uncertainty to the future fiscal path of Italy and may contribute to higher spreads. The election planned for September 25 will hopefully provide more clarity on the sustainability of the Italian public finances.