By Samuel Indyk and Medha Singh
LONDON (Reuters) -Analysts have downgraded estimates for European corporate earnings at the fastest pace in seven months this week, setting a lower bar for beats, while more optimism over the global outlook might spare shares from severe punishment for misses.
Third-quarter earnings are expected on average to have increased 3.7% from a year ago, according to data from LSEG I/B/E/S, driven by growth in materials, financials, and utilities.
However, the ratio of downgrades to upgrades of analysts' European earnings estimates has reached its highest since February as the region's economy struggles to generate meaningful growth.
"Expectations have come down quite a bit, particularly with the economy weakening," said Frederique Carrier, head of investment strategy at RBC Wealth Management.
"If numbers are better than expected, I would expect the market to react quite positively," Carrier said.
As third-quarter earnings season kicks into high gear, this theory is facing a tough test. Shares in French luxury group LVMH dropped on Wednesday by the most in a year, down 6%, after reporting weak quarterly sales.
And late on Tuesday, Dutch tech company ASML (AS:ASML)'s results showed earnings beat expectations, but a downbeat outlook triggered the largest one-day sell-off in its shares since 1998.
In the second quarter, earnings misses were punished more than they had been historically. However, some analysts believe this quarter might be different, as investors turn more optimistic about the global growth outlook.
"Investors are happy to look through the China weakness," said Georges Debbas, head of European equity & derivatives strategy at BNP Paribas (OTC:BNPQY).
China is a critical market for many European sectors and Beijing's recent announcements of large-scale stimulus measures, although light on details, have offered some hope that the world's second-largest economy can again drive global growth.
Finance Minister Lan Foan pledged over the weekend that Beijing would do more to stimulate economic growth, which data due on Friday is expected to confirm remained subdued in the third quarter.
The health of China's economy matters more for European companies that depend more on exports than their U.S. rivals, which generate most of their revenue in their vast home market.
But many investors say they remain cautious until they see further details about China's stimulus plans, including the size of the proposed package.
"There will be hope that the stimulus package can be positive for companies that have suffered from weak consumption in China," said Josephine Cetti, chief strategist at Nordea.
"(But) I don't think companies will change estimates based on what we've seen, because we haven't seen anything concrete yet."
RELATIVELY CHEAP
Among consumer-facing industries hit especially hard by weakness in China are luxury retailers, such as LVMH and Kering (EPA:PRTP), and automakers.
Investors have been shunning Europe's auto sector because of softening volume growth and heightened competition from China, particularly in electric vehicles, despite valuations close to record lows compared to the benchmark STOXX 600 index.
"The auto sector for us has been uninvestable for years," said Eddie Kennedy, head of bespoke discretionary fund management at Marlborough, citing high capex spending, low margins and increased competition.
More broadly, though, cheap valuations and light positioning offer opportunities for investors.
While the STOXX 600 is within 1.5% of record highs, European companies trade close to a record discount against their U.S. counterparts at about 37%, based on the price-to-earnings ratio.
"Valuations are relatively attractive," said Ben Ritchie, head of developed markets equities at abrdn.
"I don't think we'll see anything in the third quarter that will change that picture."
Investor positioning in Europe is also broadly neutral according to most metrics. Citi strategists highlight that investors are slightly net short Eurostoxx futures, one of just three indexes from a number that they track that has a net short position against the backdrop of mostly bullish equity positioning.
"It's not like S&P 500, which is trading at extremely high valuations, extremely high positioning, extremely high overcrowdedness that if a big AI scare happens, you could see a large correction," BNP Paribas's Debbas said about the STOXX 600.
"In Europe, I don't think that's going to be the case."