Business

Editor: Bruce Meng
29 Oct 2008 04:44:26 GMT

LONDON, Oct 28 – A stream of profit warnings from European corporates is set to become a torrent in coming weeks, but the equity markets have factored in most of what will be thrown at them.

Company chief executives will use the current reporting season to get bad news out of the way as both developed and emerging market economies deteriorate and as lending in credit market remains tight, market strategists said.

Individual companies that issue profit warnings or cut guidance may still face heavy punishment at the hands of investors, but broadly speaking, stock valuations have already priced in a bleak earnings picture.

Some strategists are seeing profit falls of more than 10 percent in 2008 and around 30 percent in 2009, and they know companies have their own reasons for painting a black picture as black as possible.

"It’s getting to the tipping point where it’s in their interest to talk the numbers down as hard as they can because what they want to do is to get into the position where they have brought the earnings estimates down to such a low level that looking out six months they can actually start to beat them," said Philip Lawlor, chief portfolio strategist at Nomura. Europe’s biggest mail and express delivery company, Deutsche Post, warned on Monday that its 2008 and 2009 operating profit would come in lower than previously expected, joining Daimler, PSA Peugeot Citroen and Air France-KLM who had all recently issued profit warnings.

Data from 41 of the DJ Stoxx 600 companies that have already reported third-quarter results showed that 51.2 percent came in below forecasts, while 46.3 percent beat forecasts, according to Thomson Reuters figures.

"Q3 is a golden opportunity for any CEO to have a profit warning or a guide down numbers because macro data have deteriorated in the third quarter for domestic economy in Europe and UK," said Nick Nelson, UBS’s head of equity research.

The British economy shrank 0.5 percent in the third quarter of 2008, much worse than expected, and the first contraction in 16 years, making a recession all but inevitable.

In Germany, business expectations plunged this month to their lowest level since the country was unified in 1990, a leading survey showed, stoking fears of a deep recession in Europe’s largest economy.

"The area where CEOs have been bullish — the emerging markets — obviously has deteriorated as well in the last quarter. There is a huge concern of tightening of credit availability. That provides perfect reasons, or excuses if you like, for companies to give a profit warning," Nelson said.

Investors have pulled out of emerging markets across the board in unprecedented volumes in the past month as global recession fears mount, terrified of risk and in some cases worried new capital controls might stop them getting out later.

The International Monetary Fund would provide funding to Iceland, Hungary and Ukraine, and is in talks with Turkey and Belarus.

UBS cut its earnings growth forecasts to down 10 percent for 2008 from a previous fall of 7 percent, and expected earnings to fall 16 percent in 2009.

Morgan Stanley, however, was more pessimistic for 2009, revising down its earnings forecasts to minus 33 percent from its previous estimates of minus 17 percent. It expected earnings growth to decline 14 percent this year.

Citigroup also estimated European corporate earnings to drop 30 percent next year.

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Market strategists said even though cheap valuations mean the market has factored in deteriorating earnings growth outlook, on an individual stock level, companies that come out with a profit warning still have the capacity to shock.

"You’ll have an announcement effect on individual stock level but in aggregate the valuations of the market seem to be discounting a fairly aggressive fall in the profits," UBS’s Nelson said.

Ronan Carr, European equity strategist at Morgan Stanley, said long-term investors could start adding to their positions as valuations were cheap.

"An earnings recession of that magnitude is already reflected in equity market valuations … We think the market is cheap but risks are high," he said.

"For a very short-term market point of view, the risks are quite high even the valuations are cheap. But if you were a long-term investor, this is … whereas you should start adding to positions."

Morgan Stanley recommended investors to long defensives, such as telecoms and healthcare, and short cyclicals like industrials.

JPMorgan also said in a note: "At market level, looking purely at the fundamental backdrop, price moves and valuations, we think a 30 percent EPS fall should already have been discounted."

Stefan Hofrichter, senior strategist and senior portfolio manager at RCM in Frankfurt, also said long-term investors could dip their toes back into the market.

"We as a house think it is not yet time to be brave. We want to wait, we want to see earnings revision momentum to stabilise. We would like to see (credit) spreads narrowing further for financial companies," Hofrichter said.

"They have come in a bit but they are still at a high level historically, too high for equity markets to perform because there are still a lot of fears about financial sector meltdown, which is not our base case."