Over the past few years, European companies have showcased surprising resilience in their earnings and profit margins, with the second-quarter earnings season once again exceeding expectationsHowever, beneath this surface success lies a more complex and challenging outlook for European corporate profitability than the current figures suggest.

As the economic landscape evolves, European businesses face notable downside risks to their earnings outlookAlthough the European Central Bank (ECB) has adopted a more cautious stance with its forward guidance, a significant number of companies reported earnings that surpassed projections in the second quarterYet, it is crucial to recognize that while the global economic cycle significantly influences corporate results, the inherent vulnerabilities in European companies' profitability paint a different picture.

Forecasts indicate that the growth rate of earnings for European firms may plateau in 2024, with predictions showing that earnings per share (EPS) could only achieve modest single-digit growth by 2025, despite market expectations of around 10% growth for that year

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Presently, the ECB is adjusting its policies and regulatory focus across five key areas: first, an imminent rotation in market leadershipWhile it appears that European firms maintained a strong earnings momentum in the first half of the year, a closer examination reveals that the cyclical sectors that have driven profitability in recent years are undergoing noticeable rotation. According to JPMorgan, sectors that are sensitive to economic cycles, such as consumer discretionary and materials, weighed on corporate earnings growth in Europe for the second quarterThis shift has been equally pronounced in the U.S., where cyclical sectors have lagged behind defensive sectors in earnings growth since the first quarter of 2022.

Second, the potential impact of a slowing global economy on European corporate earnings may surpass its effects on the European economy itselfThe uncertainty surrounding the global economic cycle is a significant reason for caution

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Companies listed in Europe have a high degree of international exposure, with revenues from local markets constituting less than 40% of total earningsThis international footprint renders European corporate profitability more sensitive to global cycles than domestic onesCurrently, the level of the global Purchasing Managers' Index (PMI) suggests that next year's earnings growth will face downward pressureShould global growth momentum taper off, the downward risks could intensifyAs a reflection of the broader economic waning, corporate guidance in the second quarter showed that 40 European companies had lowered their forecasts, most citing weak demand as the primary reasonThis figure marks the highest number of downward revisions in over a year, and it has doubled compared to the first quarterSuch trends are likely to persist into the future.

Third, despite potential cuts in central bank interest rates, borrowing costs for companies are expected to remain high

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In anticipation of a tightening cycle, many companies have extended their debt maturities, insulating themselves to a degree from rising borrowing costsHowever, as more debt matures in the coming years that needs refinancing, many firms will continue to confront higher interest rates, even as rates decreaseThus, interest expenses as a proportion of profits are on the rise, and this trend is likely to persist even under lower rate scenarios.

Fourth, expectations suggest a regression in the high profit margins currently enjoyed by European firmsProfits in Europe have remained significantly above normal levels seen post-global financial crisis, and a return to a more typical range is anticipated—especially should the global cycle slow down in the coming monthsIndustries vulnerable to these shifts, such as automotive manufacturing, are particularly at risk.

Fifth, ongoing deflation in the Producer Price Index (PPI) is set to continue exerting pressure on European corporate profitability

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Following the pandemic, domestic producers held an unusual amount of pricing power, driving their product prices upward, and high PPI inflation reflected this dynamicRecently, however, Eurozone businesses have begun experiencing drops in product prices, indicating impending pressure on profit margins and negative earnings growth.

As these dynamics play out, further implementation of accommodative monetary policies may be on the horizonThe ECB has closely monitored corporate profit margins and profitability trends, and the potential slowdown in profit growth, combined with decreasing margins, could prompt a continuation of looser monetary policies.

Challenges from supply chain disruptions, energy crises, and pent-up demand in the post-pandemic environment have led many European companies to price their products above reasonable growth marginsThis approach has allowed them to bolster profits and margins, contributing to the current disconnect between the robust earnings growth and various macroeconomic indicators