Morgan Stanley Research Europe published an investment report today titled “European Equity Strategy: When will the earnings downgrades stop?” Analyst Matthew Garman argues that the worm is finally turning for Europe and European companies, and that stocks across the continent could see a 10% increase in earnings per share in 2014.

European Stocks

European earnings should improve by second quarter

Garman points to a number of indicators in arguing that earnings downgrades are finally coming to an end, and the pendulum is beginning its swing towards earnings upgrades.

“PMIs are now at levels that, at the least, suggest fewer downgrades, or even upgrades. The IFO business expectations survey is at 108, the global revenue-weighted PMI around 52 and the European composite PMI is close to 53 – all of which suggests downgrades should alleviate. However, they have given a similar message for much of the last 6M. This is largely explained by the softening in some of the harder data. We think global GDP growth will be consistent with 10% EPS growth this year (in-line with bottom-up consensus), but while this should prove positive for earnings, the economic momentum has been softening in recent quarters. However, we expect 1Q to mark the trough in global (revenue-weighted) GDP growth – potentially marking the turning point in earnings momentum.”

European Earnings

European Earnings 2

Margins likely to increase

After almost three years of decreasing margins, another positive sign for European businesses is the nascent beginnings of a trend toward increasing margins. “Margins have been falling since mid-2011 and on some measures European profitability is below its 2009 lows. While this has been a persistent driver of downgrades, we expect that margins may actually represent a tailwind in 2014. The ratio of earnings to revenue downgrades is improving, the last couple of earnings seasons have seen in-line earnings despite top-line misses, and crucially our Margin Lead Indicator points towards margins expanding 60-70bp this year.”

Foreign exchange volatility and emerging market risks

The Morgan Stanley report highlights that investors must consider politics and foreign exchange risk before investing in European equities. MS estimates that every 10% move in the trade-weighted euro decreases European company earnings by around 3%. Garman also points out that a weakening of the euro could occur in reaction to macro economic or political events leading to further worsening in emerging markets.